2023-07-19 07:35:00 ET
Summary
- I leverage the skills of others to access areas previously inaccessible.
- You don't have to manage your portfolio alone, and funds can help you reach new areas.
- A retirement paid for by dividends is my ultimate goal.
Co-authored by Treading Softly
I have always enjoyed trying to figure out how to do things on my own. I recognize that I may not be an expert in everything, but I also recognize that there are many things I can do on my own without having to pay someone else to do it. I'm not alone in this. The entire reason that Home Depot or Lowe's continues to thrive is not just because of contractors but because so many homeowners or renters strive to do things themselves that they visit those stores to purchase goods.
But I also know my limits. When it comes to electrical work, I will doubtlessly hire an electrician. When it comes to plumbing, I will hire a plumber.
Why is this the case? I've realized that there are limits to my ability to do things myself and that some things can be dangerous or cause extensive damage that I don't want to pay for later. So I hired a professional in that field to do the work for me.
When it comes to the market, modern-day investing apps have really helped democratize the stock market. Previously, you'd have to look at tickers in the newspaper to see what their daily change was. Drive down to your local brokerage, or call them, and talk to a broker to make a trade, all while paying out massive fees simply to buy or sell a security. While this caused a lot of investors to be longer-holding type investors versus traders, it also meant large swaths of the market were unapproachable to retail investors.
What we're seeing now is that retail investors have a wider grasp on different types of investments and are able to more readily make purchases of those investments. But we're also seeing that investors are more frequently becoming traders than becoming true investors who buy and hold. Yet not every corner of the market is still accessible to the retail investor. So, how can you gain exposure to those types of corners? By using something called a Closed-End Fund ('CEF'). The fund wrapper allows you to gain exposure to sectors in the market that are otherwise illiquid or inaccessible to retail investors while leveraging the skills of a portfolio manager. Similar to leveraging the skills of a plumber or an electrician, these portfolio managers are experts in their field with years of experience. I want to take a look at an example of one such fund today.
Diving in the Illiquid
Oxford Lane Capital Corp. ( OXLC ), yielding 19.1%, is a CEF that invests in CLO Equity positions. Collateralized Loan Obligations ('CLOs') have been around since the mid-1990s, but until the last decade, they have not been investments that are accessible to retail investors. CLOs have become the primary structure for "leveraged loans," aka bank loans. These are senior-secured loans that are typically issued to companies with "B" credit ratings. These loans enjoy relatively low default rates and very high recovery rates.
Leveraged loans enjoy low default rates relative to unsecured bonds and much higher recovery rates. This is the benefit of being at the top of the capital structure. Leveraged loans are senior to all other debt that companies typically hold, like unsecured bonds and mezzanine debt.
Let's be clear, an investment in a CLO is not a debt investment. It is an investment in a vehicle that holds debt investments. CLOs are often conflated with Collateralized Debt Obligations ('CDOs'), but there are significant differences.
The largest difference is that a CDO holds a fixed collection of loans and passes along the interest and principal payments directly to investors. It is a static collection of loans that will either perform or won't.
CLOs are not fixed. They are actively managed by the manager, who primarily profits from positive returns to the equity tranche of the CLO. An individual CLO can be thought of as a mini-company. A CLO is started by the manager contributing equity and taking out a temporary "warehouse" financing to buy up leveraged loans. Once enough loans are purchased, they will then sell the debt tranches of the CLO and use those proceeds to repay the temporary financing.
You now have a company that has a very traditional structure of equity, junior debt, and senior debt. This company generates revenue from owning loans, collecting interest and capital gains, which it then uses to pay its interest due before the equity receives profits.
Initially, there is a "reinvestment period", which is typically around five years. During this period, the manager can trade loans - selling loans that are overpriced or higher risk and buying loans that are underpriced or lower risk. The manager can also use any principal repayments of the loans it holds to reinvest. This is the period where CLO managers can generate excess returns for the equity portion (and themselves).
Following the reinvestment period is the "amortization period", where cash flows are redirected to repay debt in order of seniority. There is an orderly liquidation of assets, and after repaying all the debt, the equity holders get whatever is left.
In many ways, CLOs are not all that different from Business Development Companies ('BDCs') or mortgage REITs, except they invest in a different (and typically lower risk) form of debt, tend to use higher leverage, and exist for a predetermined term.
OXLC holds equity positions in 158 CLOs, providing significant diversification from the fate of any one CLO. This also creates a lot of diversification among the underlying borrowers of the loans that CLOs hold. With just under 2000 loans and 1720 unique borrowers, OXLC has very minimal exposure to any one company. Source
With such broad diversification, we can expect that OXLC's portfolio will experience default and recovery rates that are "average". This is a great thing, as average results in a fantastic return for OXLC.
Here is a look at OXLC's GAAP "effective yield". This calculation incorporates historical average default and recovery rates to estimate the expected yield OXLC will experience over the course of the investment.
Note that this is a 15.9% effective yield at amortized cost, not at the "fair value" that is carried on the balance sheet.
The market has been punishing everything debt, including U.S. Treasuries, mortgage REITs, BDCs, debt CEFs, and other debt investment vehicles, even those that are seeing record earnings and cash flows. The market is ignoring the immense cash flows and instead focusing on the price of debt.
The average loan in the CLOs that OXLC holds is priced at 93.08% of par. Those borrowers will have to repay 100% of par. Meanwhile, any borrowers that prepay will pay 100%, which the CLO manager can then use to reinvest in new loans below par. This is fantastic for the cash flow that CLOs will produce in the future, and their income increases while their debt remains fixed.
OXLC telegraphed this by raising its dividend to $0.08/month. The market is ignoring the cash flow, and the price has barely budged. While the market is obsessed with NAV, we want to take the opportunity to buy up debt while it is very cheap. We've been buying fixed income with preferred shares, bonds, and debt CEFs. CLO equity positions aren't debt, but CLOs are companies that are buying debt. With OXLC, we can gain exposure to 158 of them and get a massive double-digit yield to boot!
Conclusion
With OXLC, we can gain exposure to CLOs, which previously were unavailable to retail investors. Major banks, huge financial institutions, and hedge funds have long been able to use and leverage the CLO system to gain exposure to massive swaths of debt. At times, even the wealthiest among us have been able to buy CLO tranches to their own benefit.
However, the retail investor, the common man, was left on the outside of this party, unable to gain access to it. Some might say that this is for a good reason, that the retail investor does not have the fortitude or knowledge, or persistence to hold a CLO investment through its lifetime.
I'll be honest, at times, investing in CLOs can be extremely volatile. It can feel like you're riding a roller coaster without a safety bar, flying downhill and hanging upside down. But at the same time, history has proven time and time again that CLO investments provide a positive total return in a wide range of economic scenarios, including even the Great Financial Crisis, to those who are willing to buy and hold while reaping their income.
So now the option is whether or not you want to go join the party. You see, before, you were simply blocked out, the door was shut, and you, the retail investor, had no access, but today the door is open should you want to go in. You're not forced to attend the party - you don't have to buy a single share of a CLO fund, but you can if you want to.
I feel that presently the risk versus reward for owning a CLO fund is heavily stacked towards reward due to the extreme yield that's provided as well as the fact that default rates on loans remain extremely low. So I have some of these funds in my portfolio because they act as a catalyst for my income - a little bit goes a long way in providing a massive boost of annual income for a retirement portfolio. With that boost, I can enjoy retirement that's paid for by dividends.
That's the beauty of my Income Method. That's the beauty of income investing.
For further details see:
I'm Buying This 19% Yield Hand Over Fist: Oxford Lane Capital