BKLN - Worried About A Recession? Time To Maximize Your Income: ECC

2023-12-11 07:35:00 ET

Summary

• Worrying about a recession is the latest investment and retirement fad, but eventually we're going to live through multiple if history is our guide.
• The best plan to survive a recession – Boost your income!
• We examine an outstanding monthly distribution paying fund that just hit a major milestone.

Co-authored by Treading Softly,

I can clearly remember the day or the time in my life when I transitioned from someone who was involved in the latest fad to someone who thought something was cool long before everybody else discovered it.

Often, as we grow older, we start crossing over from being the one chasing the local fad to the one that eventually the fads come back around to. Perhaps you were one who chased the bell-bottom jeans fad and bought some bell-bottom jeans when they were popular and cool? For some of you, you kept wearing them for decades, and they've come back to being popular again for a period of time, and you were cool before cool was cool again.

As a professional income investor, I'm not so worried about the latest fads. I'm not chasing the next Netflix (NFLX) or Amazon (AMZN). I'm not trying to win the streaming wars or gambling by rolling the dice on which artificial intelligence ("AI") stock will be the best. I enjoy something that has been needed and necessary in every single person's life the entire time our economy has existed – income. It's interesting to me that so many are willing to chase after the popular fads, but when they hit retirement age, they start worrying about where they're going to get their money to pay for things. Many of them have to sell investments to try and generate the cash to be able to pay for their lives. Some incorrectly believe that this is income instead of just recycling their capital. So, the entire time I've been in the market, I've been involved and focused on the one thing that every retiree ends up needing to worry about at the end – their income.

Today, I want to look at one security that is a massive opportunity to boost your income, even if you get a little bit of it in your portfolio.

Let's dive in!

A Clear-Headed View of Debt

Eagle Point Credit Co LLC ( ECC ), yielding 18.2%, has produced a lot of cash flow and recently crossed a major milestone: ECC has distributed $19.67/share since its IPO in 2014. Investors at IPO have received distributions that exceed their original capital invested and are still collecting $0.14/month in a regular dividend, plus a $0.02/month supplemental dividend because ECC has the "problem" of having "too much" taxable income.

Many investors love to overcomplicate investments. We are as guilty as anyone; we have written about ECC and other CLO (Collateralized Loan Obligation) funds numerous times and have described in intricate detail how they work. If you are interested in that, I invite you to check out our prior writings on them. Today, I want to zoom out and look at the big picture.

In essence, a CLO equity position is a leveraged investment in leveraged loans. What does this mean? Leveraged loans are senior secured loans that are issued by banks to below-investment-grade corporate borrowers. CLOs focus on buying up loans that are issued to corporate borrowers with a B/B+ credit rating. So 1-2 notches below investment-grade status.

A CLO buys up loans and issues debt. The capital structure of a CLO looks like this: Source .

ECC primarily buys the "Equity Tranche," but also owns some of the subordinated debt tranche. Folks love to freak out over equity being at the bottom of the structure, but when you are buying any stock through your brokerage, that is what you are buying. The absolute bottom of the capital structure. Every stock in the S&P 500 (SP500) represents the absolute bottom of the capital structure for that company.

Now, a CLO is not an operating company. A CLO buys senior secured debt in various companies, and their capital structure typically looks something like this:

When you buy common stock, which for most of you likely represents the majority of your investment portfolio, you are buying that bottom 30-50% of the capital structure. When you buy bonds, which some of you might buy because you want a "lower risk" investment, you are in that next 10-20% of the capital structure. Anyone who has ever held a bond through bankruptcy is keenly aware that bonds are not at the top of the capital stack. It is the senior secured loans, usually comprised of a revolving line of credit and floating rate "term" loans. Those term loans are what CLOs buy, and when things go poorly, they are first in line to recover. Before any of the unsecured bonds you buy, and certainly long before the equity gets a penny.

CLOs invest in this relatively low-risk portion of the capital stack, but the CLOs themselves use leverage. This is what allows investors in CLO equity positions to receive much higher yields. The debt investors in a CLO are willing to accept lower returns than if they bought the loans themselves, in exchange for having a cushion to protect them in the event of a default. The equity position gets the benefit of those higher returns.

When we invest in an asset class on a leveraged basis, we should expect higher total returns, but we should also expect more volatility. After all, leverage cuts both ways, amplifying positive total returns and losses. This is exactly what an investment in ECC has seen:

ECC has enjoyed over three times the return on NAV that the Invesco Senior Loan ETF ( BKLN ) has seen since 2015, but it has been a lot more volatile, declining more in 2016 and again in 2020 when senior loans performed poorly due to defaults.

In terms of price, both are down. ECC's price is down 49%, and BKLN's price is down about 14% since 2015.

Certainly, the recent decline is primarily driven by rising interest rates, and the prices of all debt investments are down as yields on Treasuries are becoming more attractive.

In terms of income, ECC has proven an outstanding income investment despite the volatility. Here is a look at ECC compared to BKLN, assuming a withdrawal of 9% of the original investment each year, following the Income Method rule of withdrawing 75% and reinvesting 25%: Source .

Note that the portfolio value has declined, but even though the dividend is lower than it was pre-COVID, the income produced by the portfolio was higher than ever in 2022 and has already exceeded the $900 that will be withdrawn in 2023. Using this strategy, ECC's income only failed to cover the distribution in one year – 2020. And that by only a small amount.

It has been a poor decade for debt investments. Treasuries, corporate bonds, and senior loans are all down in price, with most of the decline coming in the past two years. This isn't something that worries me, as debt will mature at par, and when it does, portfolios of debt will see their prices increase. It is a price swing that was created by the Fed, and prices will swing back up either as debt is repaid or when the Fed reduces rates, whichever comes first.

In the meantime, ECC is providing for my income needs with distributions that are more than covered by recurring cash flows:

In the last earnings call, management reported that new positions bought during the quarter were bought at an average effective yield (which is a GAAP number that includes the projected impact of credit losses) of 20.3%; this compares to an average effective yield of 16.29% at cost. In other words, CLO equity is much cheaper today, and ECC is getting a higher yield than on prior purchases. This provides ECC with potential price upside, but more importantly, it means that ECC is going to be able to maintain and possibly increase its distributions to shareholders.

Conclusion

With Eagle Point Credit Co LLC, we can invest in a leveraged play on the senior loan sector. We can receive outsized income while accepting outsized volatility. There was not a single investment available in the entire market that does not come with flaws or periods of weakness. ECC will move with the prevailing winds within the fixed-income sector, especially those that are affecting senior loans.

The beautiful thing about this fund is that it works as something I like to call an "income catalyst." A catalyst, in science, is something that can cause a reaction in other elements or chemicals, but it only takes a little bit to cause that to happen. For your income stream, a little bit of ECC can cause a massive boost in income. If you are more risk-averse and uncomfortable with higher levels of volatility, then even just a tiny bit of this fund can produce a lot of income without really offsetting your entire portfolio's balance or structure.

When it comes to retirement, we're frequently faced with either/or choices. What I don't want is those choices to be governed by how much income you have from your portfolio. Instead, I want you to have those choices be limited based on how much time you have to engage in your favorite opportunities, not dependent on how much money you have available for them. A professional income investor is able to produce the income that they need to be able to do anything that they desire from a portfolio designed to produce abundant levels of income. This way, you are financially secure and financially stable. Make time your friend, not your enemy.

That's the beauty of my Income Method. That's the beauty of income investing.

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