2023-05-18 10:51:41 ET
Summary
- Oxford Lane is a closed-end fund focused on investing in CLO equity tranches.
- With the Q4/2023 earnings release, OXLC bumped its dividend to $0.08/month.
- However, NAV declined QoQ, worse than expected, as credit within the portfolio appears to be deteriorating.
- Investors should note that OXLC has recorded 5 straight quarters of realized and unrealized investment losses despite the leveraged loan asset class performing well.
- What will happen if the U.S. economy does fall into a recession?
Recently, Oxford Lane Capital (OXLC) reported its fiscal fourth quarter results. How were the results compared to my preview , and what conclusions can one draw from the quarterly results?
NAV Declined QoQ
Since Collateralized Loan Obligations ("CLOs") are made up of leveraged loans, there is a strong correlation between the performance of the leveraged loans asset class and the CLO Equities within OXLC's portfolio. In my preview note, my regression model between the Morningstar LSTA US Leveraged Loan 100 Index ("LSTA Index") and OXLC's NAV suggested a modest MoM decline in OXLC's NAV from $5.03 to $4.88, reflecting a nominal decrease in the LSTA index in March.
In fact, OXLC's reported NAV/share of $4.61 as of March 31, 2023 (Figure 1), a decline from NAV of $4.63 on December 31, 2022 and substantially below my $4.88 estimate. It appears a small 0.1% decline in the LSTA Index in March sank OXLC's NAV by 8.3%.
Figure 1 - OXLC financial summary (OXLC investor presentation)
Core NII Plunged On Libor Basis
Oxford Lane recorded GAAP total investment income of $66.5 million for the quarter ended March 31, 2023, with net investment income of $37.4 million or $0.22 / share vs. $41.4 million or $0.26 / share in the December quarter.
Core net investment income plunged to $37.5 million for Q4/23 or $0.22 / share compared to $50.1 million or $0.31 / share in Q3/23 (Figure 2).
Figure 2 - Core NII plunged in Q4 (OXLC investor presentation)
As a reminder, OXLC calculates a non-GAAP 'Core NII' figure that includes additional cash distributions OXLC received or is entitled to receive on its CLO equity investments. According to the company's disclosure:
Income from investments in the "equity" class securities of CLO vehicles, for GAAP purposes, is recorded using the effective interest method; this is based on an effective yield to the expected redemption utilizing estimated cash flows, at current cost, including those CLO equity investments that have not made their inaugural distribution for the relevant period end. The result is an effective yield for the investment in which the respective investment's cost basis is adjusted quarterly based on the difference between the actual cash received, or distributions entitled to be received, and the effective yield calculation. Accordingly, investment income recognized on CLO equity securities in the GAAP statement of operations differs from the cash distributions actually received by the Fund during the period (referred to below as "CLO equity adjustments").
Historically, OXLC have recorded positive 'CLO equity adjustments' (see figure 2 above) in its 'Core NII' calculation. However, this adjustment figure has been trending down in the past few quarters, and in Q4/2023, this adjustment was effective nil. Hence OXLC saw a massive 29% decline in its quarterly 'Core NII' figure, from $0.31 / share to $0.22 / share.
When asked about the decline in Core NII during the conference call, management said that the decline was because of a wider than normal 1-month/3-month basis in October 2022, which impacted January payments. CLOs earn income based on 1-month LIBOR but pay interest on debt based on 3-month LIBOR, so when the basis is wide, net cash flows are negatively impacted.
OXLC also blamed an unusually large number of first-time payers making their inaugural distribution in the latest quarter. Looking forward, management believes the April quarter payments would show QoQ improvement in 'Core NII'.
Dividend Bump To Appease The Bulls
For the bulls on the OXLC story, the increase in monthly dividends to $0.08 is positive news, as many had been complaining about the lack of dividend normalization since the COVID pandemic (Figure 3).
Figure 3 - OXLC dividend still down substantially from pre-COVID (Seeking Alpha)
As a reminder, OXLC cut its monthly dividend in half, from $0.135 to $0.0675, as a result of the COVID-pandemic. Even with the latest increase, is still 40% below pre-pandemic levels.
Rebuttal For Analysts And Investors Who Claim OXLC's NAV Is Not Meaningful
As an aside, for many readers and other 'analysts' who claim not to care about the fund's NAV as they do not view it as meaningful, OXLC's current NAV of $4.61 is 32% below its December 2019 NAV of $6.81 / share. The decline in NAV is broadly tracking the decline in dividend, so perhaps NAV and dividend yields are correlated and linked.
Furthermore, OXLC's current market price of ~$5.20, down 35% from $8.05 at the end of 2019, may simply be a reflection of the decline in NAV / share, and not because the fund's shares are 'extraordinarily cheap' as many readers believe. But I disagree.
String Of Realized/Unrealized Losses Worrisome
Behind the usual cheerleading by management, the credit developments in the fund's portfolio is a little worrisome. For the quarter ended March 31, 2023, OXLC reported net realized losses of $4.9 million and net unrealized depreciation of $3.5 million. This follows net realized losses of $1.5 million and unrealized depreciation of $54.7 million in Q3/23. In fact, OXLC have been reporting realized losses and unrealized depreciation for 5 quarters in a row (Figure 4).
Figure 4 - OXLC has reported a string of realized and unrealized losses (OXLC investor presentation)
This trend of 'unrealized depreciation' and 'realized losses' is occurring when the underlying assets to CLOs, leveraged loans, are performing well, as shown by the Morningstar LSTA Index returning 6.4% on a 1Yr basis (Figure 5).
Figure 5 - LSTA Index performed well on 1Yr basis (S&P Global)
Overcollateralization Levels Highlight Risks To Portfolio
From my lens, I am cautious about the outlook for CLO equities. In my opinion, the reason CLO equities have plunged in price is because this is the expected behavior of the asset class. Remember, CLO equity tranches (which make up 96% of OXLC's portfolio) are in the CLO capital structure to provide protection to the senior debt tranches (Figure 6).
Figure 6 - CLO capital structure (guggenheiminevstments.com)
Since CLO equities are 'first loss' instruments, it is expected behaviour that their price performance deteriorate before credit concerns hit other credit investments.
For OXLC investors, I suggest they monitor closely the number of CLO equity and debt investments with negative 'Junior Tranche Overcollateralization Cushion' .
In the overcollateralization ("OC") test , if the underlying loan collateral is less than the CLO debt tranches, then the CLO is paid down from the most senior tranche downward until the test goes back into compliance. At the same time, interest is paid to the most senior tranches first.
When a CLO equity has negative overcollateralization cushion, it means the CLO is failing the OC test and the CLO equity is not paying interest (Figure 7).
Figure 7 - Negative overcollateralization is increasing (OXLC investor presentation)
When I first wrote about OXLC back in August 2022, OXLC's portfolio only had 2 CLO equity investments with negative OC cushions. In the latest portfolio update, there are 9 CLO equity investments with negative OC cushions and 1 CLO debt investment with negative OC cushion.
Issues More Shares To Buy More 'Discounted' Assets
In the quarter to March 31, 2023, OXLC issued 3.9 million shares through its at-the-market offering, raising $22.6 million in net proceeds. This brings shares outstanding to 172.1 million or an increase of 2.3% QoQ.
Bulls cheer OXLC's continued issuance of shares, as they see the company opportunistically acquiring CLO equity assets at cheap valuations.
My view is more cautious. If the assets in question are such great bargains, then why is management diluting unitholders from any eventual credit recovery by issuing more shares when the portfolio is marked down?
If I were management and I truly believed in the value of my assets, I would take excess cash and any CLO repayments to buy back common stock (instead of issuing more stock!), since that would be the course of action with the highest probability of success. Every share bought back has a 'guaranteed' 17.4% return, as OXLC would not have to pay the dividend on bought back shares. Presumably, if the portfolio is trading below 'intrinsic value', every share bought back would be accretive for any remaining unitholders.
Conclusion
Both bulls and bears could find things to like in Oxford Lane's latest quarterly earnings report. On the positive side, the company boosted its monthly dividend to $0.08, a sign of 'confidence' by management. The company also raised $23 million in new equity to put towards buying more 'discounted' CLO equities.
For bears, OXLC's NAV declined QoQ despite the underlying leveraged loan asset class performing well. Core NII plunged 29% QoQ on a widening in 1M/3M Libor basis and an unusual number of first time payers in the quarter. Finally, an increasing number of CLO investments are falling into negative overcollateralization territory, which bodes poorly for the portfolio.
Overall, I recommend caution regarding credit funds like Oxford Lane, as I believe the worse is yet to come in terms of corporate defaults and bankruptcies.
For further details see:
Oxford Lane: The Good And The Bad From Q4 2023