OXLC - OXLC: Understanding Distribution Coverage

2023-12-19 04:51:56 ET

Summary

• Distributions - whether from funds or corporate stocks - are always paid net of any corporate or fund expenses.
• Distributions covered by a fund's net investment income do not have to depend on a fund's achieving capital gains or otherwise depleting its capital to pay the distribution.
• Total Return = Cash Distributions Paid + Capital Gains or Losses.
• A fully covered (by NII) cash distribution can still end up being more than the fund's total return if the fund sustains capital losses, thus eroding its NAV and/or market price.

Summary

One of our members asked a question last month about Oxford Lane Capital's ( OXLC ) distribution yield, that I thought was important enough to answer more broadly for everyone. Here's the question:

"True" returns of OXLC? Was wondering if anyone has put together a spreadsheet showing the "after expense" return on some of the recommendations. For example, OXLC. According to Schwab, the current distribution rate is 19.59%, but the Annual Net Expense ratio is 13.14%. Does that make the true return 6.54%? Actual numbers - If I invested $100k in OXLC, would I be generating $6,540 per year in Income, or $19,590?

This sort of question seems to arise fairly often, so it is worth addressing, especially as it is essential to a basic understanding of how dividends and distributions work, not just for closed-end funds but for corporations, funds and entities of all sorts that issue stock and pay dividends.

Broadly speaking, all dividends are paid NET of any corporate or fund expenses. For some reason this concept is easy to understand when it applies to an operating company that issues stock, but sometimes tends to confuse people in the case of funds.

If Exxon or General Motors pays a dividend, investors don't expect that the employee salaries, or cost of goods sold, or other routine corporate expenditures will somehow be deducted from the dividend payments. Dividends are always paid out of the net profit of the company; i.e. the surplus that's left AFTER expenses are deducted from revenues.

The same is true of closed-end funds, or other types of funds, where distributions are always paid out AFTER fund expenses are paid.

Typically we compare a fund's distributions with its Net Investment Income (often abbreviated "NII"). A fund's NII consists of the dividends and interest it receives from its portfolio of stocks, bonds or other securities, MINUS its fund expenses. That's somewhat analogous to an industrial company's Revenues Minus Expenses = Net Profit.

The main point is that the dividend (whether from a fund or an industrial corporation) is paid out AFTER the expenses are already paid.

Here are the details in the case of OXLC:

However, NII is not the only component of a fund's Total Return. The other main element is the capital gain (or loss) in the fund's investment portfolio. A fund's portfolio can go up or down in its market value without affecting its NII. Just as our own stock or bond portfolios tend to move up or down every day. But unless we or the fund go out and sell our holdings, the profits and losses remain "paper" profits and losses, and don't affect the underlying cash income being generated.

In the case of OXLC, its NII totally covers its distribution, which currently represents a 19.5% yield on its market price (20.7% yield on its Net Asset Value, or "NAV"). OXLC's market price is currently at a 5.8% premium to its NAV.

So to answer our member's question: Yes, a $100,000 investment in OXLC currently generates a $19,500 cash yield. That's a "real" yield, i.e. actual cash paid to the shareholder. Whether it represents a "true return" (i.e. total return) of 19.5% depends on one more input: changes in the value of OXLC shares during the period.

Total Return of a fund equals the distribution yield, PLUS the gain or loss in the value of OXLC shares. As a closed-end fund, OXLC's shares have two values : a Market Value (i.e. price in the market; what we pay to buy and sell them), and a Net Asset Value (what the underlying assets per share would be worth if sold separately); so its Total Return is calculated on both its market price and on its NAV.

As of yesterday, per CEF Data , OXLC's Total Return for 2023 Year-to-Date, was:

• +13.9% on its market price, and
• +21.75% on its net asset value ((NAV))

This tells us that, in terms of its NAV, OXLC is having a very good year, in that besides its 20.7% cash dividend yield, it actually increased its NAV slightly, so the two added together (i.e. its total return of 21.75%) slightly exceeded the amount of the cash distribution alone. That's good news indeed, because frankly, in most cases when you see a cash distribution yield in double digits, especially up close to 20%, you pretty much expect the fund will be giving some of it back in price erosion, and that its actual total return will be lower than the cash distribution.

That indeed is what has happened to OXLC, when you look at its total return based on its market price. Here its total return of 13.9% is less than the cash yield it has paid of 19.5% (annualized), which suggests that the difference must represent the market price erosion experienced so far this year. In other words, you received 19.5% in cash, but gave back the difference in market price decline, for a total return of 13.9%.

The market value total return of 13.9% is still an excellent total return, and the fact that it is less than the market value yield, while the NAV return of 21.75% is slightly greater than the NAV yield, suggests that the market price must have fallen during the past year, while the NAV has risen . That means the premium has come down and OXLC is a better buy than it previously was.

Bottom Line Summary

• Distribution yields are always net of expenses, so whatever distribution is announced and declared, that's the amount of cash you're going to receive.
• If the distribution is less than the fund's Net Investment Income ("NII"),(which means it's fully covered by the NII) then you know the fund is receiving cash income sufficient to pay its distribution, without depending on or depleting its capital
• Even if a fund's NII does cover its distribution, it is still possible the fund's assets may erode in value (market value or NAV), which capital loss would show up as a gap between the distribution yield and the total return.

For further details see: