Co-authored by Treading Softly
The last time I openly stated that I was using a particular fund to bet on the success of the American economy and the success of the American people, I wrote:
“You need to have income to survive and shouldn’t rely on doomsday predictions. Time and time again, they cannot accurately predict what the default rates will be going forward for the very markets that they’re supposed to oversee. This reminds me that the U.S. economy often performs outside and beyond what others could expect it to. Many times, people have doubted the ability of the United States to continue to produce strong returns economically, or to weather storms that come, and the nation continues to prove its doubters wrong. I have learned it is beneficial to bet on the U.S. rather than against it.”
Those who disagreed with me did not disagree about betting on the U.S. economy but disagreed about particular aspects of the fund’s operation itself. They felt that management was overpaid, that the expenses of the fund were too high, and they consistently worried about its ability to provide strong total returns. I’m happy to point out to any of those who made those concerns or comments that I appreciate them for pointing out what they thought were valid concerns. I’m also happy to point out that since we last wrote about this great fund and our bet on the U.S. economy, it has outperformed even the most beloved indexes – The S&P 500 (SPY).
I will say, however, that consistently comparing a fund that invests in debt with leverage to the S&P 500 is not a good comparison over the long run. It should be compared to a fund that invests in similar debt without added leverage. For this reason, I like to use the Invesco Senior Loan ETF (BKLN). It allows you to compare your performance against a similar CLO (Collateralized Loan Obligation) investment vs. Oxford Lane Capital Corp. (NASDAQ:OXLC), which invests in the same financial instruments with leverage.
If you invested in the straight loans themselves, they posted about a 3% positive total return over the same time frame. OXLC was able to provide a +14% overall total return, largely because of the effect of compounding leverage. CLO securities utilize leverage, and OXLC applies leverage at the fund level. Leverage amplifies returns in both directions. That is unpleasant if the asset class is going down, but fantastic when it is going up.
Let’s examine OXLC’s latest results more closely and see if it can maintain its income and strong returns!
Get Paid To Keep Betting On Yourself and Others
We love it when earnings reports kick off with a dividend raise, and that is what happened with OXLC. It increased its distribution by 12.5% to $0.09/month, effective with the July distribution. What makes this raise even more remarkable is that OXLC already had a nosebleed yield of 18% before the raise. OXLC’s primary asset class is “equity” tranches in CLOs. CLOs are vehicles that buy up bank loans, typically of companies with B/B+ credit ratings, and then securitize it, paying out the returns in a “waterfall” style with the lowest yielding senior tranches being repaid first, followed by the junior debt tranches and finally the equity tranche takes on the risk of first loss, while also getting the greatest reward.
This raise is well-supported by core net investment income, and OXLC’s NAV is up 6% year-over-year. Source.
However, with the payout now a staggering 22% of NAV, it is natural to question whether this payout is sustainable over the long term. The answer is, “it depends.” As investors in OXLC, it is crucial for us to understand the moving parts that determine OXLC’s total return.
Notably, the new dividend is $0.27/quarter. That is less than “Core net investment income”, but greater than “GAAP net investment income”. The primary difference between these numbers is that GAAP NII attempts to amortize credit losses.
The cash flows from a CLO equity position are lumpy, and OXLC isn’t receiving the same amount of cash every month. Each month is dependent upon the underlying borrowers actually paying their bills. The interest payments will keep coming in all the way up to the day the borrower defaults and stops paying. As a result, OXLC could be sitting there collecting interest all along, then one month, the borrower stops paying, and OXLC will likely realize a loss on the capital.
GAAP accounting attempts to even out the reporting of the cash flows, even though the cash flows themselves are lumpy. It does this by using “effective yield”, which is the yield that can be expected to be received based on historical default and recovery rates.
Over the past year, the amount that OXLC received in cash distributions was materially higher than projected by GAAP net income. From OXLC’s annual report (emphasis added):
“We note that there may be significant differences between Oxford Lane’s earnings prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States of America and our taxable earnings, particularly related to collateralized loan obligation (“CLO”) equity investments where our taxable earnings are based upon the distributable share of earnings as determined under tax regulations for each CLO equity investment, while GAAP earnings are based upon an effective yield calculation. Additionally, as our taxable earnings are not generally known until after our distributions are made; those distributions may represent a return of capital on a tax basis. While reportable GAAP income from our CLO equity investments for the year ended March 31, 2024 was approximately $285.4 million, we received or were entitled to receive approximately $444.1 million in distributions from our CLO equity investments.”
Cash distributions were 55% higher than reported under GAAP net income. From an accounting standpoint, the excess payments are reported as a “return of capital” and decrease OXLC’s cost basis. For tax purposes, the calculation is entirely different and is based on the distributable share of earnings for each CLO. As a result, there is frequently a material difference between taxable income and GAAP net investment income.
As a RIC (Regulated Investment Company), OXLC is required to distribute the majority of its taxable income, and failure to do so results in paying an excise tax. Last year, OXLC’s 18% yield was not sufficient to distribute all of its estimated taxable income. As a result, it had to pay a 4% excise tax of $5.4 million, which implies that OXLC underpaid its distribution by $135 million (approximately $0.564/share). However, it is worth noting that the taxable income is an estimate that is subject to revision when the CLO terminates. The actual taxable nature of a CLO’s distributions is not fully known until the CLO has distributed all of its assets. OXLC’s current estimates of taxable income could be revised higher or lower in the future. So don’t put that $0.564 number in the bank. However, if conditions remain benign, that $0.564 represents taxable income that will eventually be distributed either through distribution raises, supplements, or specials. Peer Eagle Point Credit Co, Inc. (ECC) was in a very similar situation and has been paying regular supplements to reduce the amount of undistributed taxable income it has.
This accumulation of undistributed taxable income is likely the primary driver behind OXLC’s decision to increase its distribution.
Going forward, how much can we expect from OXLC? The effective yield, which includes the expected impact of defaults, has risen to 16.9%. The cash distribution, which is the actual cash received divided by the current cost, is 23.1%.
OXLC’s current distribution is in the middle, which, we believe, is a very good place to be. It is unrealistic to believe that every borrower will pay as agreed. Borrowers defaulting is simply a reality of being in the business of lending. On the other hand, default rates have been trending well below average, corporate credit is on reasonably stable ground and corporate leverage is not excessively high, like we have seen before periods like the GFC. One reason I have been so bullish on CLO equity is that COVID-19 created an opportunity for many corporations to deleverage and improve their balance sheets. As a result, below-average defaults are likely to persist this cycle.
OXLC would probably love to retain capital to rebuild book value, but tax rules require it to distribute most of its taxable income. As a result, we get an increase in the distribution because OXLC has the “problem” of making too much money. The new distribution exceeds the earnings estimates created by GAAP accounting, which means that to be sustainable, default rates will need to continue to be below average. We believe that is likely to happen; however, investors should be aware that the size of the distribution has exceeded that threshold. On the other hand, the actual cash coming in right now continues to exceed the distribution significantly. This has allowed OXLC to acquire more investments and grow its future earnings.
Conclusion
The beautiful thing about an investment in debt is that you have one of two outcomes – either you have a positive return on the money you invested, or you have a loss. This means that default rates continue to be critical in the long-term outlook of what you can expect to receive from a fund like OXLC. We’ve noticed that OXLC has been able to rebuild book value by retaining capital while continuing to pay strong income to you and me. I love it when a company or a fund has a problem that they’re making too much money. And because of their structure, they are forced to pay me more. I find that to be a win-win.
When it comes to retirement, you can never have too much income. If you have more income than you need to pay your bills and enjoy your chosen lifestyle, you can then reinvest that and readily continue to grow your income stream month after month. I like to consider OXLC to be what I call an “income catalyst.” In chemistry, a catalyst is a substance that helps speed up a chemical reaction or even cause it to occur. And they are not always required in large quantities. You can add just a little position in OXLC to your retirement portfolio and see a massive explosion in the amount of income.
That’s the beauty of my Income Method. That is the beauty of income investing.
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