I’m Betting On America With +19% Yields: OXLC (NASDAQ:OXLC)

Co-authored by Treading Softly.

At the beginning of this year, I highlighted that I was betting on America during this election year by investing in specific funds that exposed me to the wider economy.

Today, I want to update you on one of those funds and examine its performance. But before we do so, let’s review how far we’ve come since our last coverage.

Since I wrote about Oxford Lane Capital Corporation (NASDAQ:OXLC) back on January 14th, it has not only delivered market-beating total returns, but nearly matched the market with its price return. Inclusive in all of this is, the CEF delivered a massive distribution hike. Overall, my bet on default rates remaining low and the economy performing well during an election cycle continues to show strength. Since we know past performance has done very well, and we accept that past performance doesn’t guarantee future performance, let’s examine the most recent earnings update. We’ll see if OXLC will continue to provide us with strong income and great total returns going forward.

Let’s dive in!

How Is My Bet On America’s Outlook?

Oxford Lane Capital Corporation (OXLC) is a Closed-End Fund, or CEF, that specializes in CLO equity (Collateralized Loan Obligations) and yields 19%. CLO equity has been producing enormous amounts of cash as prices have remained low even as default rates have also been low.

Compared to last quarter, OXLC was stable. GAAP NII (Net Investment Income) came in at $0.22/share, exactly where it was last quarter. Core NII, which includes an adjustment for CLO equity payments, came in at $0.41/share, compared to an average of $0.395 the trailing four quarters. We expect this metric to be rather volatile.

Net asset value was $4.91/share, roughly flat from the $4.90/share last quarter. Source.

CLOs are actively managed portfolios of leveraged loans. These are loans that are generally to companies with credit ratings that are below investment-grade, typically in the B/B+ range. When the CLO receives interest payments, they are paid out in a waterfall style to the various tranches of the CLO. The A-tranches are paid in full, then the B-tranches, and the equity tranche gets to keep the extra. As a result, the primary risk that investors in equity tranches are taking on is credit risk. If a borrower defaults, the equity tranche gets less money.

One way to look at it is that the investors in the senior tranches are willing to sell off risk. The average AAA tranche in the CLOs that OXLC invests in only receives a spread of SOFR + 1.49%. The borrowers are paying interest of SOFR + 3.60%. Where does that extra money go? Into OXLC’s pocket:

Note that there are two yields. “Effective Yield” is a GAAP measure that attempts to estimate future losses. Any payments received exceeding the effective yield are not reported as interest income and are not included in the GAAP NII metric. Instead, the payments reduce the cost basis of the investment, and when the investment liquidates, OXLC will recognize a gain or loss at that time based on the adjusted cost basis.

“Cash Distribution Yield” is the amount of actual cash that OXLC received divided by their cost basis. That is the cash coming in the door right now, some of which will be offset by future credit losses.

Credit losses have been abnormally low for several years. The current trailing 12-month default rate is only 0.9%, down from 1.1% last quarter. We expect that corporate default rates will continue to be lower than we typically see throughout the credit cycle as borrowers derisked, and high interest rates have discouraged companies from taking out too much debt recently. Even among the companies that are facing financial stress, it has frequently been directly tied to interest rates, and much of the pressure will be relieved as interest rates decline. This is very different from the situation we saw in, say, 2008, where companies were coming off an extended period when taking on leverage was rewarded.

OXLC itself is an example of the type of conservative approach that many companies are taking to their balance sheets. Even if we count preferred stock and debt, OXLC’s debt-to-equity is just 0.35x:

As a result, if a recession starts next month, OXLC’s balance sheet is well-positioned to manage any volatility and could leverage up and be a buyer if prices are low.

OXLC has been using a combination of retained cash, repayments of principal, and capital raised through share issuances to continue buying up more investments. Last quarter, it had net investments of $120.5 million:

This growth is why OXLC was able to increase its distribution in July. OXLC is firing on all cylinders and easily out-earning its distribution without needing to leverage up. We expect these trends to continue.

Conclusion

I initially wanted to compare OXLC with the SPDR® S&P 500 ETF Trust (SPY), but that’s not a fair comparison. So I decided to compare its performance against a senior loan fund, Invesco Senior Loan ETF (BKLN), and an AAA-rated CLO fund, Janus Henderson AAA CLO ETF (JAAA).

Senior loans form the building blocks of a CLO instrument. JAAA is a CLO fund that invests only in the highest-rated CLO debt. Both these can arguably provide a higher degree of safety because there’s less leverage involved. However, we can see that by investing in Triple-A rated debt, you receive better returns than if you bought the loans themselves directly, but not much. You can then see that OXLC, which invests in the equity tranches of CLOs, which represent the side with high risk and high reward, has performed the strongest this year, largely because default rates have remained very low. All three funds would suffer if default rates rose above historical levels.

When it comes to your retirement, it is reasonable to anticipate strong economic conditions, but it’s important to note that it’s not a guarantee that the market or the economy will always rise and perform. There have always been recessions, depressions, and bear markets. These are all realities, but history has overwhelmingly shown that the economy continues to grow and that the market continues to rise. This is why it makes sense to tune your portfolio to maintain exposure to the economy so you can also benefit when it performs. Being an active participant in the economy, whether in the workplace or through your portfolio, can provide you with highly valuable income that you need day after day. Your expenses are never going to stop, so make sure your income doesn’t either.

That’s the beauty of my Income Method. That’s the beauty of income investing.