- 4:45 – The 2008 GFC and how it compares to 2022’s economic environment
- 10:48 – A look inside Eagle Point (NYSE:ECC)’s portfolio
- 14:26 – Potential returns and downside risks
- 16:26 – The impact of rising interest rates
- 22:01 – NASDAQ: OXLC vs. NYSE: ECC
Date of Interview: September 20th
Transcript
Jesse Redmond: Welcome to Seeking Alpha, I’m your host, Jesse Redmond. Today, I’m joined by Tom Majewski, CEO of Eagle Pointe Credit Company. Tom, welcome to the show.
Tom Majewski: Jesse, Thanks so much for having me today.
JR: So let’s start out with a bit of an overview. How would you describe your business to someone that’s not familiar with the company?
TM: Sure. Eagle Point Credit Company or Ticker, ECC invests principally in the equity tranches of U.S. dominated collateralized loan obligations or CLO’s. At a high level, a CLO is a pool of secured corporate loans, principally to a large American companies, that is has the long term capital structure within each CLO, such that each CLO sort of behaves like a mini bank in that we lend money at a high rate like banks often do, and we borrow money from creditors to close at a lower rate.
That’s kind of banking 101. Different than what nearly any bank has ever figured out how to do, CLOs borrow on a long term basis. We typically have 12-year financing in each of our CLOs. But we lend money to these companies, typically on a 5 to 7 year basis, such that, whereas many banks worry about an asset-liability mismatch where deposits can leave very quickly, as that’s happened to any number of banks over the years, CLOs benefit from having financing, that’s longer and their assets so that we can weather substantially any storm that comes our way. The underlying asset class of CLOs are something called senior secured loans or par loans or bank loans. They’re called a lot of different things. At the end of the day, are CLOs own small pieces of big loans to big American companies. As our principal investment strategy, this is American Airlines, Dell Computers, Hilton Hotels, Samsonite luggage companies you know of and do business with every day and smaller companies as well.
What was very interesting in our opinion, is that for the 30 years (ending December 2021), the Credit Suisse Leveraged Loan Index, which is sort of the S&P 500 of loans, has had positive total returns for 28 of the last 30 years. And one of those two negative returns was down half a percent. So you take an asset class that’s delivered positive total returns in substantially any market cycle. The only negative year was 2008 frankly, in the last 30. And then we apply long term, very stable financing without any mark-to-market triggers. And it provides a very nice, attractive high current income for the holders of CLO equity, which includes ECC, which allows us to pay a high current monthly distribution and also provide us ample cash to continue investing in new CLOs as market opportunities present themselves. So each CLO we think of really as a mini bank doing what banks do every day, lending at a high rate, borrowing at a low rate, but without the burden of an asset-liability mismatch and without the burden of many other things that go wrong at banks. We don’t have derivatives. There’s no derivatives business, there’s no branches, there’s no London Whales.
All the things that typically get banks in trouble is not something that CLOs are involved in. So it’s, we view it in many cases as a better bank and Eagle Point Credit Management. The advisor of ECC, is one of the largest investors of CLO equity in the world, but we believe the largest actually, and that gives us some very meaningful size and scale advantages when you invest in the CLO equity market being part of a much broader advisor portfolio.
JR: And Tom, I’m old enough to have been around here in 2008. I was working in the financial industry then and when I started doing some research on Eagle Point, one of the first things that triggered it in my head was 2008 and CLOs. Can you just kind of briefly highlight what happened back then? And do you see any similarities in today’s environment to that riskier period in 2008?
TM: Sure. Yeah. Well, actually, if we look at history, certainly we hope history repeats itself. If looking back to data compiled by Citibank, 96% of all CLOs issued leading up to the financial crisis, well over 500 cash flow CLOs, of them, 96% had a positive return to the equity class and the median return was about 15% IRR. So whereas the common perception, if you thought you might have invested in a C (blank) O just before the financial crisis, one might assume things ended quite poorly.
The reality is, if you had the staying power and saw the investments through to their full cycle, you had a return in many cases better than the kind of the contemplated base case pre-crisis and why that is, every loan that doesn’t default pays off at par. It’s a binary. Every credit has a binary outcome. One of two things…. you get your money back or you don’t. In 2009, between 2008 and 2009, the 12-month default rate peaked at about 11%. But what that means is all the other loans paid off on par and at the same time, loan prices fell significantly during that time, 60, 70, $0.80 on the dollar and loans, those that don’t default, keep paying. They make prepayments. They make amortization of payments, payments when they’re due.
And that money, that par money coming back can be reinvested, typically, for the first five years of a CLO’s life, into either new loans or in choppier markets, you invest them in loans. In the secondary market, there’s about $1.6 trillion of US syndicated loans outstanding, so that all the investment banks are big desks that have traded billions, hundreds of millions of dollars every single day ,and in a time of distress, if you’re getting hard dollars back from prepayments and amortization payments, you call up JPMorgan and say what loans they have today. They might have loans for sale at $0.60 on the dollar. You’re using your par dollars to buy those. Bringing the clock a little more forward to April of 2020. Certainly it was a very difficult time in the financial markets, there was much uncertainty in all the world. No one knew exactly what would happen. The price of loans fell to about $0.80 on the dollar in that same month. About 2% of all loans repaid at par in the syndicated loan market. And all of a sudden, you have 2% of your money coming back in at 100 when you can go reinvested at 80, and that everyone matured substantially.
Everyone made mistakes going into COVID. Very few people called the trajectory of the COVID cycle credit cycle market events perfectly. But one good way to make up for a few problems as a lender is the ability to buy some other things cheap using par dollars. So that same playbook, it was tremendous in 2009 it was, I’ll say, very good in 2020. If anything, I wish the price of loans stayed lower longer. It would have provided for even more attractive reinvestment opportunities within our CLO’s. But where we look today from an economic cycle, if we think back to 2008 which was the second part of your question, Justin, when we think about that and we look at it, historically, there have been very few soft landings.
But we look at where companies are today. And what I’ll say is that the tough times of 2020 certainly changed the way many treasurers and CFOs run their companies. Today, there’s a little more liquidity. Many companies favor longer maturities on their debt. And in 2019, we might have even called some of these lazy balance sheets at companies and you run it a little tighter, a little leaner, pay a special dividend to the shareholders, all the things private equity investors like to see happen. The reality is everyone got surprised in some way, shape or form during COVID, and that’s helped companies run with a little more liquidity. So while defaults, which have been nearly 0% for the last year or two, are creeping up hard to go below zero, we don’t see a scenario where loan defaults increase to such a material amount as to cause a big problem in the market.
But even if they did, what we would expect is the price of loans in the secondary market would fall significantly. This is not a prediction on our part, but in a scenario where 10% or 15% of all corporate American loans defaulted in the secondary market, we expect that to be trading at 60, 70, $0.80 on the dollar. in such an extreme situation. Defaults will certainly pick up. It’s hard to see them not. And we’re seeing it happen as we speak. But we see a scenario more akin to a two, three or 4% default cycle. Loans are pricing that already today many loans trade between 1990 $0.05 on the dollar. Some of the higher quality loans $.96 $.97. But there’s enough discount in the system in the loan market to be able to buffer losses that you might have from a few defaults that are going to sneak into a CLO portfolio.
JR: And when you’re building the portfolio, Tom, are there any particular themes or things that you’re looking for in these positions?
TM: Absolutely. We have a view that is very different than many in the market in that one of the things I mentioned is within CLOs is the ability to reinvest repayments and paydowns and even make some trading within each loan within the loan portfolio, sell loan A and buy loan B. Typically in a CLO today you’re able to do that for the first five years of the life of a CLO.
And thereafter, for the next seven years when payments come in, you simply repay your debt repayment. triple-A, which has the lowest cost and then the Double-A until the equity gets the principal left over. Along the way., this is very important, the equity gets all of the net interest margin, assuming the CLO is in compliance with all its tests so that we can we lend at a high rate, we borrow at a low rate that difference or net investment income or net investment margin or phrases banks use, get dividends out to CLO equity every single quarter.
That’s the kind of operating profits of interest. But where we look, even if defaults were to increase , the ability to reinvest cheaper we think is very likely to continue. One of the ways I think of CLO equity as a winning trade, as long as you’re in the reinvestment period, as long as price volatility is greater than actual credit expense, you’re probably going to do okay. In that the defaults are going to go up and down.
That’s, you know, every few years it happens. The world will, I don’t think will ever solve that problem. But when defaults are going up, nearly certainly the price of loans is falling, every loan that doesn’t default pays off at par. Now, if you’re in that five year reinvestment period, you can take those par dollars and go buy things that are on sale in a distressed secondary market.
That’s great. After the reinvestment period, then you’re just repaying your debt. You’re never forced to sell anything. But as money comes in, the principal comes in, you repay your creditors, which if you’re in a time of distress, the last thing in the world you would want to do is repay your creditors at par. So one thing we do as an investor, which I think while many other investors or some other investors at least focus on this, I think we put a very, very high emphasis on having as much remaining reinvestment period as possible in the CLOs we hold.
And one of the things, if you listen to our earnings calls or read our press releases with each earnings release, we’ll talk very regularly about our weighted average remaining reinvestment period. That’s quite a mouthful of a phrase. The WARRP with 2 “R”s we sometimes call it. But I tell our team here that WARRP can never be too high.
There’s never a scenario where we have too much remaining reinvestment period in that the number one defense when a credit cycle occurs and no one can accurately predict when they’re going to occur. Everyone always says always someone predicting one will occur. And once in a while even a wrong clock is right. Twice a day. We find that if you have the ability to reinvest your principal amounts that you receive back into those deeply, deeply discounted distressed credits or good credit spent on a distressed market, you’re going to come out as good as you expected, if not better.
So I think we focus on that more than many other investors, and I think our performance has proven us. That’s certainly proven us accurate with the Fed approach.
JR: And for the long term investor, what’s a good expectation in terms of potential returns and also in terms of downside risk to about something like a maximum drawdown?
TM: Sure. So if you look at kind of once we are fully we went public in October of 2014. By the time we got our balance sheet in place and issued some preferred stock and things like that, kind of the end of 2015. If you look at the return of our stock kind of from 2016 onward, once we had all the cash deployed from the IPO, you know, it was it was, you know, we got the money deployed as quickly as possible.
But you don’t want to do anything hasty as well. We’ve had very strong returns depending on the days you measure it. In many cases, it’s a double-digit total return since inception. So we sense that kind of January 2016 date, so that’s good. Double digit returns are always good. Then the share price has whipped around more than it should. What I’ll tell you is, if you look when our share price is down, quite often you’ll see insiders buying at. I remember in 2020 and you know, there were so many insiders who wanted to buy. We obviously had to get the NAV out and publish everything before we knew it, we had to wait a couple of days even after that.
But more than a few people said, could you get the NAV out a little more quickly because we’re ready to buy. So the drawdown, you know, the market will be what the market will be in terms of how if people want to sell the stock, which they certainly did in 2020, on average, since our IPO in 2014, our stock has been at about a 10% premium to NAV, which is very unusual for a closed end fund. We run it more like a company than a closed fund. But whereas many of these many closed end funds traded discounts over the last eight years, on average, we’ve traded at a handsome premium to NAV.
JR: It’s an interesting time where today’s Tuesday, September 20th, when we’re recording tomorrow, we’re going to have the Fed announcements expected, something like a three quarters of a point, maybe a full point. How does something like that impact your portfolio?
TM: So directly, with very limited impact. Indirectly, maybe bigger. Essentially, everything in a CLO is match funded. All of our assets are nearly all of our assets pay off of three month LIBOR. So the good news is the next time the interest rates reset for companies in October, if short term rates go up, the LIBOR or SOFR, and the longer transitioning over the reset rate in October will be higher than it was when they last reset in July.
So assuming the Fed does as many people expect, that’ll be great news. CLO debt pays floating rate as well, also off of three month LIBOR, three months SOFR. So what we get on the one side, we give on the other such that the equity is largely indifferent when holding all else equal to where interest rates are. But we’re not in a situation where we’re using long term rates on one side and short term rates on the other. It’s all typically a three month resetting paper in the case of ECC. All of our financing, however, is fixed rate. So those ECC- C’s I talked about, the ECC-B’s which we issued, those have fairly low and fixed rate coupons. So you’re able to buy them at a discount today as an investor in the markets are able to get some convexity in your purchase price, but those have five and 6% fixed rate coupons. So ECC kind of benefits, to the extent rates are going up, our assets and our CLO’s are going up in terms of their coupon, but our financing is fixed rate. Now, the consequential or indirect thing, if the Fed is raising rates, they’re trying to pull in the reins on the economy. That’s not a secret by any stretch.
At some point, they’ve raised rates so much, it hurts consumer behavior and it hurts companies ability to service their debt. That’s where, you know, rising rates is good until a point and then it becomes less good. In my opinion, we’re not to the point where these near-term rate increases that are contemplated bring companies into a default situation by any stretch. There may be one or two outliers. Of course, we lend to well over a thousand companies through our CLO’s. So when you have large numbers there will always g be one or two. But by and large, companies have sufficient coverage. The ratio of EBITDA kind of their cash profits to debt service is very comfortable for the vast majority of borrowers in the leveraged loan market. So if we wake up tomorrow and rates are seven or 8%, which is certainly not our prediction, I might have a different story, but as we’re inching our way to 3%, 4%, that’s all in the acceptable band, frankly. That also impacts consumer behavior. Anyone who is thinking about buying a house, if you bought it in March, you’re quite happy.
If you’re looking to buy a house today, your mortgage payments doubled. That’s bad as well. Depends on your perspective, I guess. But for buyers of houses and sellers of houses, if you’re a buyer, your payments going up. If you’re a seller, the price your neighbor got six months ago is no longer available to you. That certainly slows consumer behavior, and that indirectly also was a bad thing for many companies in that we like consumers to spend a lot of money.
So the Fed is getting done what they achieved, what they’re seeking to achieve. We could debate the pace. I think they’re doing a good job broadly, but we’re in a situation where we are going to see some degree of slowdown of economic activity from rates. Our broad view is that the increase in rates at the pace we’re going is not such that’s going to cause a meaningful default cycle. One other interesting way, just to kind of a little slightly different twist in addition to ECC, we also have a sister company, Eagle Point Income Company, which trades under ticker EIC on the New York Stock Exchange, and that’s also externally managed by Eagle Point income management, that portfolio, the vast majority of it, is actually straight up floating rate CLO debt, the same stuff that our CLOs issue.
We don’t buy their different securities, but the same concept of having LIBOR based three month floaters and as a benefit of having our earnings go up. … Let’s see, this year we’ve had the dividend started, distributions started at $0.12 a month, went to 12 and a half cents as of August declaration went up to $0.14 a month and our earnings in general keep going up as LIBOR and SOFR goes up.
So holding all houses constant to the extent the Fed raised rates 75 basis points tomorrow, you know, the interest rate on the vast majority of EIC’s portfolio kind of moves up dollar for dollar, whereas it kind of gets muted for the equity. It’s not a problem, but it’s not a benefit. In the case of EIC, which owns principally LIBOR based floating rate CLO debt, continued increases in coupon holding, all else equal, would be a very good thing for that company. So if you’re moderately confident on the corporate outlook and you think rates are going to keep going up, that’s an interesting investment that some investors are considering.
JR: And in my research in terms of looking at competitors, the name Oxford Lane Capital Corp often showed up. How do you see their fund and business as being similar or different from yours?
TM: Sure. So the team at Oxford Lane, there are good teams or good folks that run it. They’re our neighbors right up the street from here. They have a little more of a they invest in similar securities than compared to ECC. There’s even a few positions where we’re both in the same securities. So if you line up our portfolios, if you really want to be, you know, a securities wonk and line up schedules of investments in their annual report and ours, you’ll see in some cases, the same exact investment. So we think a lot in similar ways, probably something that’s a little different in our portfolio than theirs. I would say we have a longer, last I checked, my belief was we have a longer remaining reinvestment period in our portfolio and that I said earlier, we value WARRP more than the average investor in our market. And I think you could see that I’m not sure they published that number for their portfolio. They may have just started, but we’ve been publishing it for a while and I’m pretty sure ours is a good bit higher. So, so one thing that might be different, they’ve been willing to take risk on some shorter investments, which might have a less robust profile, in our opinion, and in a continued economic downturn They might do better if things turn around more quickly. But we like to set things up for the long term, and I’ll give up a few basis points of extra return to know if things go a little worse than we expected or even a bunch worse than we expect. We probably have the right position, the right portfolio to power through it. Certainly fine folks, Eagle Point has a fund that invests in other 40 ACT vehicles. We’ve been insiders there in the past. So it’s something we’re you know, we’re very familiar with their portfolio. We probably run a little more of a long term, a little more stable oriented portfolio than them, but definitely a good team over there
JR: And my final question is, how do you see ECC fitting into a diversified portfolio? Do you have any thoughts on how much one should allocate to a space like this or specifically to something like ECC?
TM: Sure. So a big question, and that depends on how much income are you looking at as this for an income investment or a total return investment? If you’re looking for a current income investment, you know, to pay the bills to, you know, cover your insurance payments, your mortgage payment, your rents, whatever it may be. Something like ECC could be a meaningful part of a portfolio.
Exactly what that is is a personal risk tolerance decision that folks have. But there’s few investments that are going to pay such a high, consistent monthly distribution to common shareholders. For those looking for a little more stability, our preferred stock continues to pay a monthly distribution that there’s a set due date at $25. So if you look at ECC-C which is our preferred term, there’s an exact date.
We have to pay your money back to you plus interest or you own the company. I guess in that case, which is obviously not the scenario we anticipate so far, if you give up a little bit of return, you have the potential to get an even more stable cash flow and a date with a certain return profile. If you’re looking at this as a as a total return play, we think investing in markets like this, where people are a little bit skeptical of credit, we think is usually a great time. Frankly, we’ve done some research that shows the vast majority of times when loans are below $0.95 on the dollar broadly, which is where they are today. Over the next three years, the total return on CLO equity is quite attractive. Typically there’s a dispersion of returns, of course, and obviously the future may be different than the past, but getting levered exposure to loans which has had a positive total return in 28 of the last 30 years, doing that when they have a discount and doing it with sticky, stable, long term leverage that can’t stop you out is a pretty good idea, in my opinion
So right now it’s, I think, a very interesting time to accumulate exposure to the CLO market. If you’re looking for the current income, that’s a really good piece to have. If you’re looking for just a broad total return. We have an attractive dividend reinvestment program. Its ability to compound and grow significantly is is very much available to investors to frame it We went public at $20 a share back in 2014. And since that time, we’ve paid somewhere between 13 and $16 in dividends. I’ve lost track of exactly how used to know it’s at a penny. And so it’s gotten so high, it’s, it’s enough. But if we keep going at our current pace soon enough, the original shareholders, if you bought it, the IPO will have gotten distributions in cash equal to what they paid and obviously still own their shares So for high current income investors, which a few of the Seeking Alpha columnists who follow us, they certainly focus on that current income. It’s a very nice it’s a very nice piece of a portfolio
JR: Well, this has been great, Tom, thanks for joining us and seeking help and best of luck moving forward.
TM: Great. Thanks so much for your time, Jesse. Have a great afternoon. Thank you
Be the first to comment