Investment Thesis
Investing in CLO [Collateralized Loan Obligation] Funds must be driven off an evaluation of primarily their portfolio yields and not their NAV [Net Asset Value].
What is a CLO?
Some of my readers may remember when I first wrote concerning Oxford Lane Capital (OXLC) where I delved into the basic workings of CLOs and how they function. I'm going to recap that here for clarity. I decided not to do so on a previous article and after mentioning OXLC, I received numerous questions regarding how exactly OXLC's Net Asset Value, NAV, worked in relation to their earnings.
Source
CLOs bring together two groups of people: Borrowers and lenders. Multiple borrowers or smaller loans are consolidated into one large structure, which multiple lenders provide the equity for. Different lenders will purchase various tranches, the higher rating offers greater safety but lower yields. These higher rated tranches get first dibs on payments when loan payments are made. As you work down the tranches, the yield increases along with risk. The final position is the equity tranche - it bears no credit rating, it receives payments last, but offers the greatest yield.
In the event that payments are missed or sent to collections, the higher tranches have greatest strength. This means that the equity tranche may not receive payments at times.
The Great NAV-igation Game
Lately, rising or falling NAV has drawn concern from investors regarding CLO funds. CLOs are comprised of hundreds, if not thousands, of individual loans. Those loans all have individual values which change as each loan payment is made. Pre-payment also affects the loans' values. These loans comprise the total CLO and its entire structure, which then is broken into tranches. So now those tranches have to be assigned parts of the value of the total CLO. Lastly, Eagle Point Credit Company (NYSE:ECC) and OXLC are comprised of multiple CLOs - all of which have shifting NAVs. To further confuse things, CLOs are highly illiquid assets, unlike real estate or trading in bonds, preferred or common equity. CLOs don't trade on a regular basis and typically are bought or sold on appointment only. Meaning the value of the loans within the CLO may not impact its sales price as heavily as the variations of ECC or OXLC's NAV may lead you to believe.
Imagine if you're assigned to appraise the value of a CLO. You would be dependent on whoever was assigned to value the individual loans, and if their acceptable margin of error was 10% (yes, this is exceptionally high I'm sure), now your data is only 90% accurate and your margin of error stacks on top of this. This is why I consistently tell people that determining ECC's and OXLC's NAV is an art, not a science.
CLO NAVs are based on a mark-to-market style of approach, basically what a third party determines someone might pay for the position the fund holds. This means it is highly speculative but CLO funds are required to at least quarterly determine the value of their holds and report these. Due to this mark-to-market pricing and also simultaneously due to the highly illiquid nature of CLO investments, CLO fund NAVs are often not reflective of the strength and profitability of any given CLO position.
CLOs are designed to throw off income to various tranche holders, and most CLO funds almost exclusively invest in the riskiest and highest yielding tranche - the equity tranche.
Steven Bavaria often relates CLOs to virtual banks - and this is a great descriptor. If you were to invest in Regions Financial (RF), for example, you are buying equity - or shares of the company - not its actual assets. Same here for equity tranche investors. They are getting ownership of the success of the CLO and join in the losses of it too. This position means any volatility of the suspected value of the whole CLO and the loans comprising it cause pricing swings for the NAV of the fund holding them.
Why Buying on the NAV is Deceiving
The three most readily available CLO funds for retail investors: Oxford Lane Capital, Eagle Point Credit Company and OFS Credit (OCCI) all primarily (over 90% of their portfolios) invest in the equity tranches of CLOs.
Data by YCharts
Each of these securities seems to trade irrespective of their NAVs, typically OXLC reports its NAV quarterly as required, ECC reports it almost monthly and OCCI - which is a brand new fund - has followed the quarterly pattern.
OXLC and ECC have almost always traded at a premium to their NAVs, so an investor planning on buying when they trade at a discount would be highly disappointed and missing out on the income provided. Due to the room for error within these funds' NAV calculations, NAV-based trading is best left for other CEFs where it is a fantastic tool.
Trading on Portfolio Yield vs. Market Yield
CLOs are designed to produce income. All three CLO funds publish quarterly their cost yield for their portfolios - essentially the yield their investments are making. Savvy investors will aim to invest in these funds when the market offers them at a yield above their portfolio yield - maximizing your earnings on the funds' earnings as long as the fund is covering its dividends, which at this time all three CLO funds are.
Data by YCharts
OXLC's quarterly update advised investors their cost yield was 15.7%. Meanwhile, ECC's cost yield was 13.3%. OCCI saw a cost yield of 14% but trades at a market price yield of 11%. You can see when the yields are updated by these funds, all except OCCI saw a correction to trade near their newly reported portfolio yields. OCCI has such a small volume, it currently trades at a high premium to its portfolio yield, and as such appears to be the worst choice using this metric.
ECC is the middle ground, buyers of ECC shares are receiving less income than the portfolio is receiving for their actively traded shares. Meanwhile, OXLC has been hovering right around its portfolio yield in the market and remains the best option to maximize its small discount to yield to achieve your best dollar leveraging for returns of income.
Real World Example
Let us apply this to real life for a moment. ECC saw its NAV drop heavily in December (reported a month delayed) and its yield spike due to market reaction.
Data by YCharts
An investor investing based on NAV alone would have sold in reaction to January's update to the NAV and probably would be still dodging the fund as a whole. Meanwhile, investing based on yield, the investor would have invested anytime the available yield to the market surpassed that of the portfolio, meaning grabbing the 16% yield when it became available. Although ECC's NAV dropped, its CLOs never stopped performing.
Data by YCharts
Investing based on portfolio yield vs. market yield, investors would have seen a 26.67% in a matter of months. This return pales in comparison with buying on the same dip (due to a decrease in premium vs. discount) and selling when the NAV drop was reported.
Data by YCharts
Those investing off of NAV movements would have netted a price return of 19.06%. It is important to keep in mind that the vast majority of investors in CLO funds are doing so for their income-generating ability - meaning many are investing for the recurring dividend payments. Investing in market yield vs. portfolio yield would have provided shares paying out 16% vs. the normalized yield for ECC of 12-13%.
Investor Takeaway
CLO funds are unique, their NAV and income-generation ability are not correlated one-for-one like other CEFs. This disconnect means that a different means by which to evaluate which fund is worthy to invest in must be deployed. Currently, using this method, OXLC remains the cheapest choice to achieve the best income per dollar invested vs. ECC. However, only a month ago ECC traded at a much higher discount to its portfolio yield than OXLC. So when an investor is looking to add to their CLO funds, first review the portfolio yield and then the market yields to find the best discount.
For additional CLO reading see:
CLOs: Here To Stay And Are Sound Investments
Oxford Lane Capital: Where The NAV Is Made Up And Cash Flows Are All That Matter
Eagle Point Credit: NAV Is The Lake, Cash Flow Is The River
