2023-12-11 22:39:22 ET
Summary
- XAI Octagon Floating Rate & Alternative Income Term Trust is a fixed income CEF investing in leveraged loans, CLO debt and CLO equity.
- The 6.50% Series 2026 Term Preferred Shares are a bond equivalent with a defined maturity date, making them a consideration for investors seeking safer returns.
- The preferred shares have a March 2026 maturity date, providing certainty for the return of principal, and offer a yield to maturity of 7.68% with ample asset coverage.
- Preferred shares with term maturities allow for the crystallization of the discount to par via the required principal return.
Thesis
Higher risk free rates have resulted in higher yields across the board. A retail investor can now obtain 8% yields from floating rate loans, and all in yields in excess of 10% for leveraged loan CEF structures. A CEF structure has a higher yield because it adds up leverage on top of the securities it holds, thus boosting returns. However, high return / high risk investing is not for everybody. Some might look for safer returns, with a defined maturity date and yield. That is why the 6.50% Series 2026 Term Preferred Shares ( XFLT.PR.A ) might be a consideration for those investors.
XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ) is a fixed income closed end fund with $300 million in assets under management. The company invests in leveraged loans, CLO debt and CLO equity, owning a very blended portfolio of assets:
Asset Allocation (Fund Fact Sheet)
The fund holdings are important because they present an interesting case scenario. Fixed income CEFs that contain non-IRR based assets can usually access cheap financing, and we see them fund themselves either via bank facilities or a combination of bank facilities and perpetual preferred equity. XFLT is a hybrid, and its liability structure contains both a bank facility as well as term preferred equity. In this article we are going to look at its 2026 Series Preferred Shares and outline why they are in fact a bond equivalent and currently represent an attractive potential investment.
XFLT funding structure
A closed end fund ('CEF') is a company, with assets and liabilities:
Balance Sheet (Semi-Annual Report)
On the liability side of the balance sheet, as per the March 2023 Semi-Annual report, we can find the CEF's funding structure via a leverage facility of $122 million, and the 2026 preferred shares of $42 million. Now, what is interesting is that the preferred equity is reported on the liability side of the balance sheet rather than on the equity side. This is due to the structure of the preferred shares and the accounting surrounding such instruments.
As per Deloitte, preferred stocks that contain an unconditional obligation of the issuer to redeem the instrument for cash, are considered liabilities rather than equity. This is done to ensure a company does not simply circumvent debt covenants by issuing preferred equity with a term maturity:
ASC 480 (Deloitte)
XFLT.PR.A have a term maturity scheduled for March 2026, as per the offering prospectus:
Maturity Date (Prospectus)
Having a scheduled term maturity (meaning the CEF cannot postpone the return of principal) captures the shares under ASC 480 and thus forces the CEF to recognize this instrument as a liability rather than preferred equity.
For a retail investor, what is important to remember is that the contemplated instrument in effect acts as a bond, with a defined maturity date, and the subordination provided by the common shares. This feature is extremely important because in addition to the current yield the instrument provides, we can now also compute the yield to maturity. The yield to maturity ultimately captures the discount to par value that said retail investor will get upon maturity date.
Yield calculations
A bond represents an obligation by a company to make timely interest and principal payments. 'Principal' refers to the loaned amount. A series of preferred shares with a term maturity in effect represent a bond-like instrument for yield considerations, although they might not have the same claim on the collateral in case of a bankruptcy. Mind you, a bankruptcy for a CEF means the common shareholders are completely wiped-out.
The 2026 Series has a March 31, 2026 maturity date, which allows us to calculate both a current yield (which you can find on the Seeking Alpha primary page) as well as a yield to maturity:
Yield Calculations (Yield To Maturity)
At the current price of $24.38 per share for the preferred equity, the equivalent yield to maturity is 7.68% as per the above calculations. This means that a retail investor holding the preferred shares to maturity will get an all-in yield of 7.68% per annum for their cash. Given the shares are trading fairly close to par, the current yield of 6.8% offered by the preferred shares is not substantially off from the yield to maturity, however it is lower given the shares are trading at a discount to par.
Why are the preferred shares attractive?
The defined maturity date makes these preferred shares resemble a bond, thus ensuring certainty for the return of principal feature. The remaining tenor is 2.3 years, thus an investor basically buying a short term bond. Two year treasuries are currently yielding 4.8%, thus the spread pick-up here is almost 300 bps, or 3%, for a collateral covered instrument.
Buying into the preferred equity of this CEF gives the holder seniority to the common shareholders. In effect the asset coverage ratio is at 161% here:
Asset Coverage (Semi-Annual Report)
A regular corporate bond relies on the assets of a company to return principal to shareholders. It is the same concept here, only that we think the recovery here is closer to 100% for the preferred shares. Furthermore, an investor is not taking single issuer risk (think about buying BP bonds before the Deepwater Horizon explosion ) but has exposure to a very well diversified portfolio of loans and CLO debt and equity. When you buy a bond from a specific corporate, you are exposed to intrinsic unforeseen events that can affect that company and thus your bond investment. For this particular CEF, you need to have default rates go above 10% for leveraged loans with 0% recoveries for several years to be concerned about not getting your money back in the preferred shares. And even then, the fund would breach coverage ratios beforehand thus needing to de-lever.
The take-away for a retail investor is that the preferred shares are extremely robust from a recovery / asset coverage perspective, and you can sleep well at night without concerns around not getting your money back. In such an instance, getting 3% over equivalent maturity treasuries is a very good deal.
The preferred shares are term, the common might not
An informed reader needs to note that the common shares might not be term soon :
October 26, 2023 06:30 AM Eastern Daylight Time
CHICAGO--(BUSINESS WIRE)--XAI Octagon Floating Rate & Alternative Income Term Trust (the “Trust”) (NYSE: XFLT), announced that the Trust’s Board of Trustees (the “Board”) has unanimously approved a proposal to eliminate the Trust’s termination date of December 31, 2029. The proposal, if approved by shareholders, will amend the Trust’s Second Amended and Restated Declaration of Trust and make the Trust perpetual (the “Term Amendment”).
The above announcement is pertinent to the common shares in the CEF, and the conversion of the management company to a perpetual one. Most CEFs are perpetual, thus the above is not surprising. However, please note the respective corporate action has nothing to do with the preferred shares or their term maturity (which cannot be changed).
Conclusion
XFLT is a fixed income CEF. The vehicle invests in leveraged loans, CLO debt and CLO equity. The CEF leverages itself via a bank facility and a term maturity preferred equity series. The preferred equity has a March 2026 maturity date and ample asset coverage. Issued as preferred equity, the series is classified as a liability line on the balance sheet, and benefits from the subordination of the common shares and the asset coverage from the portfolio. With a 7.68% yield to maturity, the instrument represents an almost 3% spread pick-up over equivalent duration treasuries, thus constituting a very attractive investment.
For further details see:
XFLT.PR.A: Get A 7.68% Yield From This Bond Equivalent