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Summary As high yield bond and corporate loan markets continue to be hammered by nervous investors, funds like OXLC and ECC have seen their NAVs drop even more. This is a natural result of their leverage, but essentially is irrelevant to their ability to generate cash flow and make their dividend payments. These are tough vehicles for some retail investors to understand and appreciate, but offer impressive income potential to those willing to make the effort. As the proverbial blood continues to run in the streets of the high yield bond and leveraged loan markets (because of a range of fears related to the Fed increasing rates, the world economy slump, etc.) the non-investment grade companies that comprise those markets continue to go about their business, making their interest and principal payments. This translates into strong cash flows and high distributions for Oxford Lane Capital Corporation (NASDAQ: OXLC ) and Eagle Point Credit (NYSE: ECC ), the two closed end funds that specialize in buying collateralized loan obligations (“CLO’s”). CLO’s are leveraged, special purpose vehicles that function like “virtual banks,” buying and holding senior, secured floating-rate loans to non-investment grade companies. (This is the same cohort of companies that issues high-yield bonds. But whereas high-yield bonds are unsecured and typically recover only 20-30% in the event of the issuer’s default, senior secured loans have historically recovered 70-80% in the event of default, so the overall credit loss on a portfolio of loans over time is less than half the credit loss on a portfolio of high yield bonds.) Both ECC and OXLC put out quarterly reports yesterday and followed up with investor conference calls this morning. In both cases the messages were similar, that the market for the assets they hold – CLOs and the loans held by CLOs – are way down, the cash flows from those assets continue strong, and the reinvestment opportunities for CLOs in the loan market are very attractive. But the strong income prospects this represents (OXLC yields over 22% and ECC over 14%) are not enough to offset the fears of many closed end fund investors, who remain fixated on the net asset values (NAVs) of both funds. These have dropped in recent months to reflect the depressed markets for their underlying assets. Here is why the NAV of a CLO fund would drop as the market for its underlying assets drops. Suppose the equity in a typical CLO is leveraged 10 times. If the market for the loans held by that CLO drops by 1%, then the mark-to-market or “paper loss” to the equity of the CLO will be 10 times 1%, or 10%. This means that investors should not be surprised to see NAVs of ECC or OXLC fall at about ten times the rate as the drop in market prices in the loan market. None of the drop however, has any relation to the ability of the portfolio to generate the cash needed to pay distributions. Investors who can understand that and be comfortable with it can appreciate the opportunity these funds represent for income investors. But be prepared for a potentially volatile ride in terms of market value, although many of us who have owned the funds for awhile may feel – given the current entry point versus where we got in – that today’s new investors will have a smoother ride than we did. Scalper1 News
Scalper1 News