A Cool, Mysterious 17% Yield: Eagle Point Credit (NYSE:ECC)

Co-authored by Treading Softly.

The ocean makes up about 70% of the Earth’s surface. Humanity has always loved exploring the ocean, jumping aboard ships of different sizes to reach the open seas. However, under it is often noisy The surface is a dark and mysterious world. Even with our rapid technological advancement, Only 24.9% The global sea floor has been mapped. The surface and ocean floor are only part of the equation. When we take into account the total volume of the ocean and its various depths, only 5% The ocean is an explorer.

Why is so much of the ocean unknown and inaccessible? Because it is very difficult and dangerous. Humans cannot breathe underwater, so we need equipment to survive for any length of time below the surface. To go deeper, you have to deal with perpetual darkness and Huge crushing pressure from the weight of the water above you. If you are It goes up very quicklyYou could experience nitrogen bubbles in your tissues; If you go down too deep, your ship will be crushed. The world was rocked by the failure of a deep-sea ship last year When it exploded While visiting Titanic.

So, how does this relate to investing? I’m glad you asked.

When it comes to the market, we all have a finite circle of competence. We can only know so much by reading, experimenting, and investing in our brokerage accounts. However, outside this circle there are many strange and little-known investments that are the creation of the giant financial institutions that make up our economy. You cannot access these investments because of your limited tools. Must possess precise tools and specialized skills; Otherwise, you may see your results disastrous.

To access these obscure income streams, I employ CEFs (closed-end funds) and their specialist management teams. It allows me and other investors to pool our resources, put them in the hands of an expert, and leverage these income streams.

Today, we’ll dive deeper into one of these opportunities.

Let’s dive in!

Use experts to reach difficult places

Closed-end funds typically do not report “earnings.” They update their NAV daily, publish their holdings, and perhaps release a quarterly update without much fanfare. Mutual funds focusing on the collateralized loan obligations sector have taken a different approach. Like many other companies, it issues earnings presentations and holds conference calls. They choose to be taxed as funds, but they operate very similarly to an investment company like a REIT or BDC. Like real estate or private loans, CLO shares are illiquid. It is an asset that CLO funds buy, usually with the intention of holding it until maturity.

Eagle Point Credit Company LLC (New York Stock Exchange: ECC), which yields 16.9%, is one such fund that focuses on CLO stocks. A CLO is a securitization portfolio of senior secured loans. “Securitization” is a practice in which a pool of loans is sold to investors in parts on a priority basis. Institutions will pay a huge premium to the “top” tranches, which get the first tier of cash flow. In exchange for a much lower return than the basic portfolio, the top tranches get a lot of security.

Subordinated debt tranches take on more risk and get a bit more reward. Who will benefit from the huge premiums that major lenders are willing to pay? Stocks. The equity tranche gets “whatever’s left.” source.

As the recipient of “whatever’s left,” the equity tranche exists to insulate the debt tranches from credit losses. If the borrower defaults, the equity tranche absorbs the loss and has a lower return. If the borrower does not default, the equity tranche collects a lot of interest payments and gets repaid the principal at maturity.

Have you ever been to a banquet or wedding where those doing the cleaning spread out piles of food because there was more than was needed? That’s what’s happening to CLO stocks right now — “whatever’s left” turns into massive piles of cash.

Since the beginning, ECC It paid $20.47 per share in dividends.

She extended her $0.02 per month supplemental distribution through September because the 16.5% yield from the “regular” distribution wasn’t enough to keep up with her taxable income.

In the first quarter of 2024, ECC saw its recurring cash flows decline to “just” $0.70 per share.

This is where an earnings call comes in handy because management explained the down quarter:

We received recurring cash inflows into our portfolio in the first quarter of $56.2 million, or $0.70 per share. We previously noted that recurring cash flows in Q1 were impacted by higher prepayments in Q4 2023, which resulted in little cash drawdown within many CLOs. This has since been normalized.

In fact, during the month of April, we received recurring cash flows of $65.7 million, which is significantly more than the recurring cash flows received in each of the previous two quarters.

So, in April alone, ECC received approximately 17% more recurring cash flow than in the entire first quarter. ECC issued a lot of shares in the first quarter, increasing the number of shares from 76.9 million to 85.3 million. Even adjusting for this new share count, April’s recurring cash flows are $0.77 per share, with more cash due in May and June.

Additionally, management mentioned on the earnings call that the price of CLO debt they held had risen, and they were selling it in the second quarter to reinvest in higher-yielding CLO equity positions.

The bottom line is that ECC’s cash flow is already high relative to its net asset value and stock price, and it will rise.

The main threat to ECC returns is default. After all, in exchange for the massive cash flow ECC receives, it takes on the role of protecting debt investors from default risk. As we predicted several years ago, defaults remain very low this cycle, with the 12-month default rate at 1.14%, well below the historical average of 2.7%. When selected, ECC outperforms average, with only 0.68% default in ECC’s portfolio in the trailing 12 months.

High interest rates are putting pressure on some companies. However, during the global pandemic, many companies have taken steps to shore up their balance sheets. The uncertainty surrounding the economy has encouraged conservative balance sheet management. Therefore, even with rising interest rates, the majority of borrowers are strong enough to manage the impact. For debt investors, this reality, coupled with high interest rates, creates a situation where we can get fantastic returns.

ECC pays a high dividend, and indicators in the near future suggest that dividends will continue to rise. The main risk is that we see a rise in corporate defaults and losses. ECC management said on the earnings call that it expects default rates to rise — from around 0%, there’s really only one direction to go. However, they remain well below historical averages, and they expect default rates to continue to rise much lower than many expect. We agree.

Conclusion

Collateralized loan obligations constitute a huge portion of US economic debt, but most investors do not have direct access to this pool of income. To access it, we must use funds such as ECC. Collateralized loan obligations are often confused with other exotic and riskier inventions in the financial sector, and this confusion leads many to avoid them altogether. Instead I chose to invest in solid income generating funds like ECC, allowing their management to extract massive income from the CLO ocean and reap the rewards. Do they get paid for it? definitely. If you’re skilled and knowledgeable, you’ll rarely do your work for free.

When it comes to retirement, you don’t need to make a career of exploring the depths of America’s debt markets and digging in its trenches. Alternatively, you can benefit from the experience of others and earn huge income in your account. To this day, the ocean is still a place where many people travel and visit to enjoy the freedom of the open seas and the thrill of exploration. If this is something you love and enjoy, you can use our unique income method to be able to take care of your money. This way, you only have to worry about where you want to take your next trip without a care in the world.

That’s the beauty of my income method. That’s the beauty of income investing.