Understanding Oxford Lane’s NAV Rise (NASDAQ:OXLC)

[Originally published February 5 for Inside the Income Factory members.]

Understanding Oxford Lane’s NAV Rise

Anyone who’s been watching the loan market recently will not have been surprised when Oxford Lane Capital (NASDAQ:OXLC) announced today that its January month-end Net Asset Value (“NAV”) was 9.5% higher than its year-end NAV estimate a month ago.

CLO equity values, from a theoretical accounting perspective, directly reflect the price of the loans that CLOs hold. Like the equity value (or “net worth”) of all funds, companies, other entities, or even individuals), the equity value of a CLO (“collateralized loan obligation”) equals the value of its assets minus its liabilities. Assets can go up and down in market value, but the amount of debt we owe generally remains the same. So changes up or down in asset value are directly reflected in the equity. Therefore the recent increase in trading prices in the corporate loan market would be expected to cause a rise in the equity of CLOs. That should boost the NAVs of funds that hold CLO equity, like OXLC and its Greenwich, CT neighbor, Eagle Point Credit (ECC).

This chart shows how loan prices have increased from a low of 92 cents on the dollar back in November, to about 93 cents in December, to just above 94 cents recently.

This confirms the trend we reported on to our members last week, that clearing yields for newly issued HY bonds (top of chart) and loans (bottom of chart) were still significantly higher (like twice as high) as they were a year ago.

Putting the information from the two charts together suggests that:

• The bargains we have been taking advantage of in the loan and bond markets still continue, but……
• They won’t last forever, since the huge discounts we’ve seen recently are starting to diminish, if only gradually.

Bottom Line

The decrease in discounts in the loan market probably means that the market is less scared of a recession than it was previously. Not that there may not be one, but the expectation of a smaller recession or “softer landing” seems to be somewhat greater than it previously was. Given that the market had apparently been pricing in a catastrophic economic downturn, I think our credit investments should be more than covered even if we were to end up having a more serious recession than what economists now seem to be expecting.

The recent rise in NAV for OXLC (and presumably for other CLO funds as well) will be welcome news to many investors who have been spooked by the drop in NAV values. On the other hand, we should remember that there is another side to the story. As we have described on other occasions (like this one) the accounting doesn’t always tell the whole story about CLOs and their business prospects. Just because a CLO’s loans may drop in terms of their mark-to-market value, that doesn’t really mean the CLO is worth less as a business, even though its accounting equity may drop.

That’s because, at maturity, CLOs collect the principal of their loans at par (100 cents on the dollar), regardless of what the market price of that loan may be. In practice this means that CLOs routinely collect repayments from their loan portfolio, at par, and then turn around and reinvest that cash in new loans they buy on the secondary market at discounted prices (currently about 95 cents on the dollar; a month ago at 92 cents on the dollar). That boosts the immediate yield on the loan, since the coupon is divided by the purchase price (92 cents, or 95 cents, etc.) rather than by 100 cents in order to calculate the yield, so an 8% coupon may become an 8.6% yield. But there is more, since the 5 cent or 8 cent discount accrues over the 4 or 5 years to maturity, adding another 1% or 2% to the annual yield.

This helps ordinary loan portfolios, like those held in the senior loan funds we hold. But it really helps highly leveraged portfolios like those that CLOs hold, which are typically leveraged 9 or 10 times, so a 1 or 2% increase in spread from a particular loan gets magnified in its impact to the CLO equity bottom line.

This is why CLO managers often post their best results during periods of market turmoil, like the 2008/2009 crash. It’s also why CLO fund managers have been so optimistic about their current prospects, as the credit markets price in greater economic trouble than we will likely experience.

Besides holding funds like ECC and OXLC that own CLO equity, we also own senior loan funds like Ares Dynamic Credit (ARDC), Apollo Tactical Income (AIF), Apollo Senior Floating Rate (AFT), Blackstone Long-Short Credit (BGX), and of course VVR which just boosted its current distribution by 22% a couple weeks ago. The net asset values (NAVs) of these closed-end loan funds reflect the current market value discounts on the loans they hold (i.e. 94 or 95 cents on the dollar, even though the funds will collect a capital gain when the loans pay off at par.) As investors, we get to double up on that discount when we buy the funds at a discount from their NAVs, which is the case with most of our senior loan funds at the moment.

So some of the same “discount dynamics” that are benefitting OXLC and other CLO investors currently, are also at play (although not nearly as leveraged in their bottom line effect) in the senior loan closed-end fund sector.

[Note: As this article is just about to go to press, I see where ECC has just announced its NAV is up in January as well, as suggested in the article it would be (link here).]