Wake Up And Smell The Cash Flow: Eagle Point Credit Yield 17% (NYSE:ECC)

Co-authored by Treading Softly

This past Mother’s Day, I splurged on a gift for my wife. My wife and I are both heavy coffee drinkers. We love the smell. We love the taste. We love the experience of having a good cup of coffee or espresso drink. So this past Mother’s Day, I bought her a coffee machine that cost in excess of $1000. For us, this seemed extremely pricey, considering that we’ve always enjoyed a good Mr. Coffee machine that can be bought for $30.

Some of you may remember that this past spring, I was in an accident that caused me to be injured and unable to write for a number of months. During this time, my wife was forced to not only take care of our household but also all of the various animals that we have ownership of and caretaking of. So I felt it prudent that even though it was an expensive machine, that would be one that was well worth purchasing for her.

Since I have further recovered, I have taken great joy in being able to ensure that there is a coffee-based drink for her every morning. She gets to wake up and enjoy the smell of coffee being prepared or already prepared for her. When it comes to the market, there is little more that I or many investors enjoy than receiving cash into our account on a regular basis. One of the first things I do when I look at my portfolio is review what dividends have been paid to me because these are irrevocable returns from the market. It is cash in hand that can never be taken away from me. So when I find a fund or a company that is paying me strong double-digit yields that are entirely covered by cash flow, I like to think of waking up to a hot cup of coffee. Enjoying the smell of coffee is just like waking up and enjoying the smell of strong cash flow.

Today, I want to look at one great opportunity that does just that.

Let’s dive in!

Here’s Your Morning Cup of Cash

Eagle Point Credit Co LLC (NYSE:ECC), yielding 17.4%, had the “problem” of making too much taxable income last year. CEFs (Closed-End Funds) are required to pay out most of their taxable income, and when they fall short, they have to pay an excise tax and distribute the excess the following year. ECC made more taxable income than they could distribute in 2022, and as a result, ECC has been showering us with extra dividends. On top of the already impressive $0.14/month, ECC paid out two large special dividends in 2022 and has been paying an extra $0.02/month in recent quarters. The $0.02/month extra has already been declared for the remainder of Q4.

We certainly cannot count on the $0.02/month supplemental dividend to continue into 2024. We might have to settle for “only” $1.68 in annualized dividends next year, for a yield of over 16% on today’s current price.

Since its IPO, ECC has paid out over $19.03/share in dividends, and it IPO’d at $20. Source

How is ECC able to provide such a huge income? ECC invests in securitized vehicles called “Collateralized Loan Obligations” or CLOs. When a CLO is formed, the manager buys up a portfolio of leveraged loans. These are senior secured loans that are issued by publicly rated companies. CLOs focus on the market segment that has slightly below investment-grade credit in the B/B+ range.

Senior secured loans are the most senior debt that a company usually has. It is senior to unsecured bonds and common equity, which is what you are buying when you invest in a common stock.

Typically, senior secured debt is going to be lower yielding than unsecured bonds – after all, it is significantly lower risk. However, even with “lower” risk, there is a limit to how much debt any bank or other financial institution wants to have invested in credit risk assets. After a bank originates a loan, they usually want to sell it off. A very large number of these loans are sold to CLOs, which frees up capital for the originator, and provides investors with an opportunity to invest in a portfolio of loans, rather than take the risks of a single loan.

Of course, there needs to be a way for CLOs to ensure they have enough demand that they can raise enough capital to buy up loans. To attract investors, CLOs “securitize”, meaning they sell various tranches to investors in payment priority. The senior debt investors pay a premium and accept a lower yield than the borrowers are paying in order to be first in line. This ensures that they have minimal and usually no credit losses. They get a much lower yield, but it is much more predictable.

The payments then cascade through the structure, with each tranche getting paid in full before the next lower tranche can be paid.

The “equity” tranche is the last one to get paid. As a result, it carries the most variability and the highest yields. These are the tranches that ECC buys, and the cash yield has been sky-high. ECC has received $3.18 in cash distributions from CLOs from the end of Q2 2022 to Q2 2023; its NAV at the end of Q2 2022 was $10.08. So ECC realized an actual cash yield on its NAV of 31.5%! That is looking backward at actual realized cash flows.

This has been enough to easily cover the fund’s expenses and its elevated distributions.

It is worth noting that cash flows from CLOs are variable. If a borrower defaults, the equity portion absorbs the impact. In the case of late 2022, there was an expansion in the difference between 3-month LIBOR/SOFR and 1-month LIBOR/SOFR, which had a temporarily negative impact on CLO equity which pays interest based on 3-month LIBOR/SOFR, but borrowers have the option to pay either 1-month or 3-month.

Today’s environment is creating a very unique opportunity for CLO equity positions because CLOs are not static investments like other securitized investments you might have heard of. For example, if you invest in a CMBS (Commercial Mortgage-Backed Security), you are investing in a specific portfolio of mortgages, in some cases, only a single mortgage. If that mortgage defaults, your returns can go up in smoke. You are entirely reliant on the performance of the specific assets that were in the CMBS when you bought it.

CLOs are dynamic. The manager actively manages the CLO. There is a “reinvestment period” where if a borrower refinances or otherwise prepays the principal of a loan, the manager reinvests it in new loans. If a particular loan is downgraded, or the manager determines that a loan is too risky, the manager will sell the loan and replace it with a different one. Managers are incentivized through the covenants with the senior debt tranches to minimize the number of C-rated loans in the portfolio. Remember, the manager owns much of the equity tranche and so is incentivized to maximize the returns for the equity.

What is happening today? A lot of loans are trading below par. And it has little to do with the particular risk of a loan; it has to do with the Fed and how quickly they have raised interest rates causing the pricing of most loans to be below par. Yet companies still need to refinance and push out maturities. When a loan is trading at $95 out of $100 par, the borrower still needs to repay $100. So when they repay the loan, the CLO receives $100 for something that was valued at $95, plus gets the opportunity to buy a new similar loan that is also trading at $95. So instead of having $100 in par value that has a market value of $95, after a repayment and reinvestment, the CLO would have $105 in par value at a market value of $100. The amount the CLO owes to its senior tranches remains unchanged. The gain goes to the equity tranche.

Repayment rates have slowed down, but repayments are still happening at a 14% rate.

Why would loans repay in such a high-interest rate environment? Various reasons – companies want/need to deleverage, some are acquired and the buyer might have access to cheaper capital, and others might be willing to refinance early even in a high-rate environment to extend their maturities and avoid having a wall of debt that might be challenging to refinance in the future. This activity is directly beneficial to CLO equity positions and will result in gains that will help to offset any rise in defaults that might happen.

ECC has responded by raising capital, taking advantage of trading at a premium to NAV to issue shares, plus retaining the excess cash flow it has after paying the dividend and buying more CLO equity positions.

The cash is flowing into CLO equity positions and into ECC. We are ecstatic to take advantage of this high yield. It’s time to wake up and smell the cash flow.

Conclusion

It is uncommon to find a closed-end fund that is generating so much cash flow that it has been forced to pay special dividends on a regular basis. While many funds will underpay throughout the year in order to have a special dividend at the end of the year to entice investors, ECC is generating so much cash flow that they are not only paying special dividends at the end of the year but also every month.

In the context of agriculture, farmers will often refer to a bumper crop as a crop that has been harvested in excess of what is typical and considered a very prosperous year for that crop. Similar to this, ECC is reaping so much cash from its investments and its ability to reinvest excess cash flow to buy new positions that they are forced by regulations to put more money into your pocket, while the rest of the market seems to be struggling against high-interest rates and trying to be able to cover their spending in cash flow.

When it comes to retirement, I can think of no better opportunity than a fund that is forced to pay me more because they’re doing so well at earning cash. When they pay me special dividends, I’m able to use those for whatever I want, whether that’s to buy more shares, go out on a fancy dinner with my wife, buy her flowers, or splurge on a nice coffee machine so that I can treat her to something special every morning.

When was the last time that your portfolio treated you to something special because the holdings you have are so successful that they were forced to pay you extra? My Income Method is not designed simply to make you a living that you can scrape by on, but rather, it’s designed to help your portfolio generate so much cash flow that you have an abundance of excess income. It can help you achieve true financial security and financial independence by allowing you to stop living paycheck to paycheck or Social Security deposit to Social Security deposit.

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