Oxford Lane Capital (NASDAQ: OXLC) is a closed-end fund that invests primarily in the equity tranche of Collateralized Loan Obligations or CLOs. OXLC recently announced its results for the quarter ending March 31. The results were solid as OXLC continues to rapidly build its CLO equity portfolio.
Oxford Lane is a unique closed-end fund. There are few vehicles that allow retail investors to access the depth of credit markets. One such corner that often remains untouched is that of secured loan obligations. These investments are often reminiscent of the Great Financial Crisis when guaranteed toxic debt bonds caused an economic collapse. Unfortunately, the baby was thrown out with the bathwater and the public was left with a bitter taste because it was basically securitized debt. This is unfortunate as there are significant differentiating factors between the three largest vehicles, CLOs, CDOs and CMOs. Oxford Lane focuses exclusively on CLOs, particularly the equity tranche, which we will describe shortly.
Secured Loan Obligations, or CLOs, are securitized portfolios of senior secured loans. Senior Secured Loans are asset-backed loans made to middle market companies that are often unable to independently access capital markets. Many of these loans are simply too risky to stand on their own. However, when constructed as a portfolio, the risk profile becomes more attractive. Now let’s take this concept of diversification and add another layer of risk management. The loans are grouped together in a portfolio which is then securitized or combined into a single investment vehicle. This single investment is then divided into layers called “slices”. Where a typical fund or portfolio divides the income distribution based on a prorated ownership share, CLOs are entirely different.
There are two distinct types of tranches, debt tranches and equity tranches. As with a traditional capital structure, debt has a higher claim on incoming cash flow. CLOs are typically structured with tranches of debt rated AAA, AA, A, BBB, BB. The AAA tranche must be paid in full before the AA tranche receives a cascading cash flow and so on. The idea is that the cash flow of the vehicle as a whole is greater than the need for each tranche of debt. This means that non-performing loans will have no impact on the inflow of cash from higher rated debt tranches. Higher-rated tranches are typically sold to large funds and institutions due to their attractive risk profile.
As mentioned, the vehicle’s cash flow at origination covers the distribution to debt tranches with headroom, hence the stability and attractiveness of the CLO structure. This additional cash flow is diverted to the equity tranche. The originator of the CLO retains the equity tranche or sells it as well, often offering an extremely attractive return. The risk is that the principal tranche is almost guaranteed to evaporate or shrink over time due to non-performing loans. Remember that the portfolio is made up of secured loans to insolvent businesses.
OXLC invests almost exclusively in the equity tranche of CLOs. The fund targets the riskiest tranche of stocks for two main reasons. First, these are often overlooked because large institutions buying tranches of debt may not find the risk profile attractive, increasing their availability to investors such as OXLC. Second, the attractive return generated by the performing equity tranches.
Shareholders benefit from a high level of transparency in the OXLC portfolio, relatively speaking. CLOs are inherently opaque, however, OXLC takes steps to provide clarity to shareholders. The company goes so far as to publish a list of holdings in its quarterly investor presentations. However, to take a brief overview, the fund currently holds 2,015 CLOs with almost 1,700 obligors. Diversification is essential, with the top ten holdings representing only 3.34% of investments. The single largest obligor represents less than 1.00% of the entire portfolio.
The portfolio generates an incredible return for shareholders. Based on current share prices, the fund is yielding over 13%, which translates to a monthly distribution of over 1%.
Understanding the Fund
A key consideration of the fund is that the senior secured loans are variable rate. As interest rates rise for the first time in years, the fund’s investments will improve as interest rates attached to loans rise along with federal rates. The fund’s performance was undeniably strong. Shareholders are often initially spooked because OXLC’s share price has fallen significantly since the IPO. With a few small missteps along the way, the management has done a solid job of navigating a complex and unforgiving ecosystem.
It is important to look at the investment from the right point of view. Often investors are locked into a growth mindset. You are looking for an investment that will take off like many of the big names in the market over the past two decades, such as Apple (AAPL) or Microsoft (MSFT).
Applying this mindset to OXLC will leave you disappointed. A more appropriate comparison would be something along the lines of mining. The equipment needed to extract and collect minerals from the earth will never be more valuable than when purchased, hence the concept of depreciation. However, this does not negate or overshadow the value of what you extract.
OXLC and similar funds such as Eagle Point Credit Company (ECC) will almost inevitably decline in share price over long-term horizons. However, patient and astute investors will notice that the distribution generated by these tranches significantly outweighs the pace of decay.
OXLC easily outperformed investment grade and high yield bonds over longer time horizons at the expense of volatility.
On May 6, the fund announced its fourth quarter results informing shareholders of investment income and net asset value. The fund also reaffirmed its monthly dividend of $0.075 per share until the end of September. Earnings were strong across the board as equity tranches maintained their performance and OXLC continued to make new investments and recycle capital into new investments. Net investment income and basic net investment income were $0.24 per share and $0.43 per share, respectively. Total investment income decreased by approximately $2.3 million between the last two quarters, a decline of approximately 4%.
During the quarter, OXLC made additional investments of nearly $352 million and received nearly $102 million in CLO sales and refunds. Additionally, the company issued 13 million shares during the quarter, increasing the total number of shares outstanding by approximately 10%.
However, these measures were largely overshadowed by the drop in net asset value per share which spooked investors. Over the past three months, the net asset value has decreased by $0.37 to $6.56 per share. Net asset value is often an important metric for credit investors evaluating risk and performance, because bonds are constantly marked to market. However, a crucial concept behind net asset value is liquidity. The NAV estimate is almost worthless if you are unable to trade at that price in a short time.
Liquidity in traditional equity and fixed income markets is unstoppable, as a steady stream of transactions between investors, brokers and makers provides immediate price updates for millions of securities. Secured loan obligations do not benefit from the depth level. The number of participants in the CLO market is limited. Thus, there is not a deep flow of transactions to reinforce pricing. Additionally, CLOs are actively managed, which means that CLO managers can buy and sell bonds in the portfolio, which makes valuation even more complex. These factors combine to make NAV a less meaningful metric for measuring CLO performance.
Investors often pay short-term attention to the “fair value” of these investments, rather than the proverbial gold mined by our machine. What business owner would value the book value of their drilling rig more than the value of the gold mined?
Oxford Lane is truly a unique company. Retail investors have few options for accessing securitized debt and OXLC has a proven track record of strong performance. As one of the only funds operating in the CLO space, Oxford Lane’s only real competitor is Eagle Point Credit Company, another closed-end fund dedicated to investing in and originating CLOs.
It should remain clear that despite solid and reliable historical performance, investing in CLOs is risky. The 13% dividend yield has always been enough to offset the risks, but a major credit crisis could change that quickly. The impending rise in interest rates could challenge debtors as their interest charges begin to rise. Unprepared or heavily indebted borrowers could face significant stress. However, senior secured loans have always been a way to weather the storm, as the secured structure provides strong recourse for lenders.