OXLC - OCCI: 34% Yielding CLO Fund Shows Pitfalls Of Yield Chasing

2023-09-22 13:29:55 ET

Summary

• OCCI, a small closed-end fund, has adhered to our previous thesis and lost almost 40% since then.
• The fund is primarily focused on CLO equity, with CLO debt making up just 14.1% of the total.
• OCCI's distribution yield is now at 34% and the fund is trading at a decent discount.
• An upgrade is warranted.

When we wrote of OFS Credit Company Inc ( OCCI ) one year ago, we focused on key metrics that matter. Yes, the distribution yield was among those four, but it was the least important piece of the puzzle. What we said was the following:

With this combination of 20% distributions, 12% expenses and 40% leverage, we are 100% certain this fund is going to have it rough in the next 12 months.

Source: 20% Yielding CLO Fund, But Other Numbers Matter More

The fund has adhered spectacularly well to our thesis and lost almost 40% since then. The large distributions, only offset half of this abysmal performance.

We examine why we are where we are, and where we go next.

The Fund

OCCI is a relatively small closed end fund with total assets of less than $100 million. They have taken care to diversify their industrial exposure, though.

On an underlying issuer basis, their diversification is even more impressive. The top 10 issuers make up less than 5% of the total assets. So no single name is going to make or break this fund.

The fund is a CLO fund but within that space, one can invest in debt or equity. OCCI is primarily focused on CLO equity, with CLO debt making up just 14.1% of the total.

This is a change though from the past. The first time we looked at this fund, it was even more heavily weighted towards CLO equity.

CLO debt is safer, but the bigger factor is the underlying rating of the issuers. It is here you can see the pool that OCCI is really swimming in.

The ratings are at the low end, and it is here that you get promised terrific internal rates of return, while reality usually goes in the opposite direction.

Recent Results

Investors tend to hang on to the core net investment income or Core NII. They tend to believe that as long as this "covers" the distribution, they are going to have zero issues.

The last quarter was no different with Core NII coming in at a blazing $0.62, handily "covering" (and you will get the significance of those quotes in a moment), the distributions. If you go back and check, the core NII has been in the general ballpark of the distributions.

Here are another two quarters to make our point.

So if you added all these up, you would get the sense that OCCI was overpaying, but not too radically. That would get investors into a comfy zone of thinking that there was a massive double-digit yield that was almost covered. The reality is rather brutally different.

Since inception, the price of OCCI is down 65.71%. If your distribution was (almost) fully covered, why are you down almost 66%?

The total return on price has been negative 17.67%. We show XAI Octagon Floating Rate & Alternative Income Trust ( XFLT ), Oxford Lane Capital Corp ( OXLC ) and Eagle Point Credit Company ( ECC ) as comparatives. The best two of these have barely managed 4% compounded returns over this timeframe.

Getting back to OCCI, the fund was started in 2018 and this experiment has now run five years. The distribution has been maintained, and the initial investors are now running 15% short annually versus where they thought they would be, as returns have been negative 3.5% annually versus the 12% annual that they expected. This is a very important point that the chronic bull chiming misses. Even if OCCI (and the rest) do deliver some periods of good performance, they struggle to create any long term value and are sources of significant portfolio anchor. They are never going to come close to even beating less exotic investment choices.

Outlook & Verdict

You are here for the catnip, so here, have some.

Never mind that the fund has a negative total return since inception. 34% of their own money coming back to them is still appealing to the masses. Even if you are going to get the bulk of it in the form of new shares, only 20% of the distribution is being paid in cash.

All said and done, the smaller the fund gets, the more problematic the expense ratios are going to become. OCCI is in deep trouble here, with total assets contracting over time. Its expense ratios were already huge before, and they are likely to get larger. In the next 12 months, we are likely to see some big credit headwinds from the interest rate hikes that are already in the pipeline. Don't get us wrong, some of this is already happening.

But it is likely to get worse and OCCI is going to be taken for a bath once more. So in all likelihood, you are not going to "earn" your 32% distribution yield, over the next year. Not even close. We would be shell-shocked if the fund delivered even a flat total return over the next 12 months. That said, we are giving this an upgrade here on a tactical basis. The reason is that as bad as this fund has been, it is now trading at a 15% discount to its last released NAV.

Its 3-month Z-score is at an extreme.

Of course, since NAV is not released daily, there is some guess work involved here. But, XFLT, does release its NAV daily and assuming the two are in the same postal code, we can extrapolate that things have not really deteriorated in the CLO space in the last three weeks.

So OCCI is now trading at a 15% discount, and we won't push the bear call. We are upgrading this to a "hold" with the caveat that the rating is often one we use even when we could not be paid to actually hold the security in our account. It is the rating that best amalgamates the extremely poor long-term outlook with the likely 15% bounce on shorter term timeframes. We will watch this carefully to see if it merits another downgrade after a possible bounce.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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