OXLCM - OXLCM: Short Dated 6.8% Yielding Portfolio Enhancer

2023-11-15 06:29:31 ET

Summary

• Oxford Lane Capital Corporation is a Closed-End Fund that predominantly invests in Collateralized Loan Obligation equity.
• The fund employs term preferred shares and unsecured notes for leverage due to challenges in traditional fixed-income funding for volatile asset classes like CLO equity.
• The preferred equity issuance for OXLC has a term structure, with the obligation to redeem all outstanding term preferred shares at respective maturity dates without amendments, providing certainty for investors.
• OXLCM is the first series to mature, providing a robust 6.8% yield until its June 2024 maturity date.
• The preferred shares have seniority to common equity, and exhibit a high asset coverage ratio, that currently stands at 3x.

Thesis

Oxford Lane Capital Corporation (OXLC) is a closed end fund. The management company focuses on CLO equity investments, and sports a very high market value of $1.1 billion. The fund achieves its 32% leverage ratio via preferred shares and unsecured notes:

In the CEF space there are several ways to achieve leverage:

• bank financing facilities (either Repo or Total Return Swaps)
• preferred equity issuance
• unsecured notes (the least utilized method)

Each CEF tailors its financing structure based on the underlying asset class. For OXLC the underlying asset class is highly volatile, and in the case of bank facilities it would only get a 50% LTV with a cost of SOFR plus 150 bps or more. This is due to the disadvantageous capital treatment for CLO equity when it sits on a bank's balance sheet. Furthermore, many times during market stress, banks might curtail financing lines to very risky collateral pools such as CLO equity. This is the main reason OXLC obtains its leverage via term preferred shares and unsecured notes.

In this article we are going to analyze the 6.75% Series 2024 Term Preferred Shares (OXLCM) issued by the CEF, and highlight why we think this is a very appealing short term high yielding opportunity for a portfolio.

How to structure the funding for a volatile asset class

As mentioned above, volatile asset classes like CLO equity attract high capital requirements on banks' balance sheets, thus traditional fixed income funding facilities come in at a high cost. That is why OXLC has its liabilities structured via preferred shares and unsecured notes. However, even its preferred shares issuance is a very particular one:

All of the preferred equity is done via term structures, which is unusual for this asset class. Usually preferred equity is perpetual, with an optional redemption date that starts five years after issuance, and a floating rate that is more punitive that kicks in if the shares are not redeemed. Not for OXLC:

The Fund is required to redeem all of the outstanding Term Preferred Shares on their respective redemption dates, at a redemption price equal to $25 per share plus an amount equal to accumulated but unpaid dividends, if any, to the date of the redemption. The Fund cannot effect any amendment, alteration, or repeal of the Fund's obligation to redeem all of the Term Preferred Shares without the prior unanimous vote or consent of the holders of such Term Preferred Shares.

Source: Semi-Annual Report

The reason for this term structure for the preferred equity is the nature of the underlying asset class. CLO equity is an IRR based asset class, meaning it does not have a traditional principal return feature. Classic fixed income involves the payment of interest and return of the principal (i.e. amount invested). Nor for CLO equity. As the name implies, CLO equity is the most junior piece of a CLO structure, and it receives cash-flows throughout the life of the deal, but no set 'principal' amount. That is why CLO equity is quoted in IRR terms upon issuance under a market base case.

In essence, lenders in OXLC can find themselves funding a vehicle where there are no assets if there is no term structure for the liabilities. That is why we see defined maturity dates for all the preferred equity tranches here.

OXLCM is set to mature in June 2024, and as per its documents the CEF cannot alter the maturity dated without the vote of 100% of the holders of the preferred shares. So if a retail investor buys 100 shares here and they want them redeemed in June 2024 as per the stated terms, they will get their money back on that date, namely $25/share.

Yield considerations

OXLCM is redeemable at $25/share, and has a stated coupon of 6.75%. It is currently trading at $24.75/share, which gives holders a robust short dated 6.8% yield:

The interest is paid monthly, hence the preferred shares offer a continuous stream of income until their term maturity date.

With 6 months treasury bills yielding 5.5%, a retail investor can have a yield pickup in excess of 130 bps here by investing in OXLCM for a set 8 months tenor.

Asset coverage

What is attractive about OXLCM outside its term structure is the underlying asset coverage. The preferred shares rank senior to common equity, and are thus backed by the asset pool held by the CEF. This is not the preferred equity of a company that has intangibles, but of a CEF which holds a significant amount of high yielding securities:

To that end we can see the preferred shares having a very high asset coverage ratio per unit, which currently stands at 3x. As per its definition:

Asset coverage per unit is the ratio of the carrying value of the Fund's total assets, less all liabilities and indebtedness not represented by senior securities, to the aggregate amount of outstanding senior securities, as calculated separately for each of the Term Preferred Shares, the Notes and the previously terminated Master Repurchase Agreement ("MRA") with Nomura Securities International, Inc. ("Nomura") in accordance with section 18(h) of the 1940 Act. With respect to the Term Preferred Shares, the asset coverage per unit is expressed in terms of a ratio per share of outstanding Term Preferred Shares (when expressing in terms of dollar amounts per share, the asset coverage ratio per unit is multiplied by the involuntary liquidation preference per unit of $25).

In a nutshell the asset coverage ratio gives a retail investor a sense of the ability of a CEF to cover its liabilities. The lower the ratio, the riskier the contemplated preferred shares.

The 2024 preferred securities are the least risky portion of the CEF's funding base since they have the closest maturity date of the structure, and thus the fund would need to lose in excess of 70% of the value of its underlying assets until June 2024 for a holder in OXLCM to be concerned.

Conclusion

OXLC is a CLO equity CEF. The fund achieves its leverage ratio via preferred equity and unsecured notes issuance, but what is particular about its funding base is the term structure. All of the issued preferred shares have a set maturity date, similarly to the unsecured notes.

The first to mature is the 6.75% Series 2024 Term Preferred Shares which trade under the ticker OXLCM. The preferred shares have a June 2024 maturity date and offer a 6.8% yield, which translates into a 130 bps pick-up over similar maturity treasuries. OXLCM benefits from a 3x collateral asset coverage, and is the first piece of the OXLC liability structure set for maturity.

We are of the opinion that OXLCM is a robust portfolio yield enhancer given its substantial asset coverage and spread pick-up over risk-free treasuries. We are a buy here for the name.

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