OCCI: Reaping Benefits From Improving CLO Conditions

Overview

Closed end funds remains one of the best places to collect a higher yield in today’s market. The unfortunate part of closed end funds is that they get a bad reputation because of their scary looking price charts over time. OFS Credit Company (NASDAQ:OCCI) operates as a closed end fund that shares a similar type of chart that tend to scare away investors. OCCI primarily invests in collateralized loan obligation equity and debt securities and has a public inception only dating back to 2018. The fund aims to provide an attractive total return that is mostly comprised of high current income.

We can see that since the fund’s inception, the price has declined by a massive 60.7% and this was over a short span of 6 years. If we include the distributions as part of the calculation, the total return is actually closer to 11.5% since the fund’s inception. The dividend currently sits at a massive 18.6% and can be a highly appealing asset class for income investors. However, seeing a fund with kind of performance would automatically get dismissed by most investors and I wouldn’t blame them. Despite this, I actually believe that this may be one of the most attractive times to buy a CLO focused fund such as OCCI.

In order to thrive with closed end funds such as OCCI, an investor needs to understand the underlying approach and structure that is involved. While the past performance may be scary, the strategy and portfolio focus that OCCI has is structured to benefit from the cut of interest rates. On the flip side of this, collateralized loan obligations can be very sensitive to interest rate hikes as they can result in a rise of default rates and earnings underperformance. The unfortunate truth is that OCCI never really received a fair chance to operate under normal market conditions and this may skew some investors’ perspective. However, lets first start off by assessing the portfolio strategy here and what makes OCCI so appealing at this premium to NAV level.

Portfolio Strategy

A CLO is a group of loans that are pooled together into one package. This debt is typically corporate loans with credit ratings that are below investment grade. Since CLOs typically consist of lower quality debt, they have higher than average interest rates which helps balance out the sense of risk versus reward for investors. The higher risk profile is effectively offset by the higher yields offered. Similar to a regular corporate capital structure, there are tranches of safety and quality. OCCI maintains one of the highest possible risk profiles by having a large exposure to CLO equity. There is a helpful illustration that explains the breakdown of a CLO below.

Since OCCI has a majority exposure to CLO equity, the risks can be elevated as the equity tranche is the first to absorb any losses related to defaults. According to the latest fact sheet, OCCI’s portfolio consist of a 76% weight in CLO equity and a 23.3% weight in CLO debt. A positive is that the portfolio maintains a high level of diversity across industries to minimize sector concentration vulnerability. OCCI has a majority focus on high tech industries, accounting for 9.7% of underlying obligors. This is followed by exposure to banking, finance, insurance, & real estate, accounting for 9.4%.

Performance

The closest peers to OCCI that come to mind would be Eagle Point Credit (ECC) and Oxford Lane Capital (OXLC), which both maintains a portfolio of CLO equity investments. When comparing the three funds against each other in return, we can see that OCCI has actually outperformed in terms of total return and price change. While this may not continue into the future, it’s a good indication of the fund’s current strength in relation. Fellow analyst Damon Judd, explained in his article how OCCI implemented a change in the distribution policy about a year ago, which may be a contributing factor to the fund’s ability to retain a greater amount of earnings.

ECC sports a competitive dividend yield of 18.1% and OXLC has a dividend yield of 20.2%. All of these funds share the same monthly payout schedule, being attractive options for income investors. So how sustainable are these distribution payouts? Well, it ultimately comes down to the fund’s ability to generate net investment income that can cover the distribution will some excess that can be retained to attribute to NAV growth.

Looking at OCCI’s performance over the last year, we can see that the NAV has fallen from $8.48 per share down to $7.34 per share. However, it looks like the net assets has increased over the last year, now amounting to $117.6M. This is a sizeable increase from the prior year’s total of $91.7M. Overall, OCCI seems to in great shape with the investments at fair value growing year over year while the fund’s liabilities simultaneously decreasing year over year. OCCI also has a healthy amount of cash on hand, sitting at $15.3M that can be used to offset any headwinds or even allocated towards new investments when the opportunity arises.

Dividend

A period of higher interest rates increases the likelihood of strong income generation from a portfolio of floating rate investments. As a result, more of this income gets passed along to the shareholders in the form of a distribution raise! The dividend was recently raised by 9.5% to $0.115 per share, bringing the current dividend yield up to a massive 18.6%. An added bonus to OCCI is that the distributions are paid out on a monthly basis, which adds to the flexibility and appeal for income investors that use the cash generated by their portfolio as supplemental income to fund their lifestyle expenses.

In terms of stability, the fund has been able to support the current distribution rate since inception. Core NII growth as of the latest Q2 update amounted to $0.53 per share. If we covert the monthly payout of $0.115 per share to a quarterly payout by multiplying it by three, we get $0.345 per share. Core net investment income landed at $0.53 per share for the quarter, which means that earnings cover the distribution by 154%. Therefore, long term shareholders can sit back and relax as I currently see no threats to the distribution rate.

Since the yield is already at such a high double digit rate, I do not necessarily expect there to be any distribution raises. I am happy with the strong distribution coverage but if you want growth, you are able to still get that by essentially creating your own growth through reinvestment. I back tested an original $10,000 investment at the start of 2019 to present day. The blue bars represent the levels of income year by year and assumes that all dividends were reinvested back into OCCI. Lastly, this graph assumes that no extra capital was invested other than the distribution reinvestments. In 2019, your annual income would have totaled $1,390. Fast forwarding to 2023, your full year income would now be $2,574.

The best part about this income growth chart is that it doesn’t take the added dividend reinvestment plan discount into consideration. OCCI offers investors the chance to essentially capture an instant 5% return when reinvesting their distributions back into OCCI. While I cannot confirm that all brokerages can support this discount, I have seen success with Fidelity being able to support these type of discount reinvestment plans.

On June 1, 2023, our Board adopted a change to our DRIP so that common stockholders may now receive a number of shares based on 95% of the market price per share of common stock at the close of regular trading on The Nasdaq Capital Market on the valuation date fixed by the Board for such distribution (i.e., the payment date), providing a 5% discount to the market price, which provides a benefit to common stockholders enrolled in our DRIP

Valuation & Outlook

Since OCCI operates as a closed end fund, the price can vary from the underlying value of its net assets. As a result, the price currently trades at a slight premium to NAV of 2.3%. This may look like a poor entry when considering that the price traded at an average discount to NAV of 5% over the last three year period. However, I believe that there is a good chance the premium will continue growing into the future if interest rates start to get cut soon. Since OCCI maintains a portfolio of underlying holdings that are sensitive to interest rate changes, a lower interest rate will ultimately provide relief to its underlying pool of borrowers by decreasing the cost of debt maintenance. This can free up capital for borrowers and decrease the rate of defaults, which will improve the quality of OCCI.

As previously mentioned, OCCI never really got the chance to operate under a normal interest rate environment. Back in 2020 when rates were cut to near zero levels following the pandemic, the price of OCCI rapidly moved back upwards after the initial drop since this favored borrowers on a floating rate basis. Borrowers experienced lower interest expenses and had the ability to obtain debt financing at some of the the most affordable rates. However, this started to reverse as interest rates were aggressively hiked over 2022 and 2023.

As we can see, the price of OCCI rapidly retracted to the downside as interest rates continued to get hiked. OCCI’s price has only recently stabilized over the last few months with anticipation around interest rate cuts providing a bit of relief. Therefore, a lower interest rate could serve as a positive catalyst for growth going forward and I believe that these cuts will be coming before the end of 2024 based on recent economic indicators.

For instance, the unemployment rate has continually trended upward and now sits at 4.2% as of the latest August report. Rising unemployment can be linked to a more conservative consumer and as households start to cut back on their spending levels, this may incentivize the Fed to provide a bit of stimulus through rate cuts. Additionally, we have the US Presidential elections upcoming still and this may create a market environment of elevated volatility and uncertainty. Data compiled by JPMorgan has revealed that over the last 40 year time span, there was only one election year in 2012 where there were no changes to the federal funds rate. While this doesn’t definitively prove that rate cuts will happen this year, it’s a good source of reference to show has frequently rate changes were implemented during election years.

Risk Profile

Since these CLOs are generally comprised of lower quality debt, there will always remain the risk of defaults. The federal funds rate current sits at a decade high and can be associated with higher default rates as the rising cost of debt becomes a burden for companies that may have weaker balance sheets or underperforming expectations. According to the US CLO historical tranche defaults between 1994 and 2013, defaults are impressively lower than one might think. We can see that most of the defaults are within the B-rated credit tier. While the market anticipates rate cuts happening soon, there’s still a possibility that these are once again delayed. A period of higher rates would translate to a higher probability for defaults within OCCI’s portfolio and can negatively impact NAV growth.

Looking at the credit quality makeup of OCCI, we can see that most of their exposure is to B and B- rated obligors. There is also some exposure to the worst rated debt ranging between CCC+ to D. For reference, anything rated under a BBB- is considered to be ‘junk’. Therefore, the large majority of OCCI is comprised of these junk rated debt investments and investors should make sure they clearly understand the asset class they are exposing their portfolio to.

While a lower interest rate can provide a bit of relief for current obligors, it can also translate to lower earnings. Since a lot of these investments operate on a floating rate basis, the amount of earnings that can be generated may be impacted by lower net investment income. This could also impact the NAV growth and distribution coverage cushion if OCCI is unable to offset these impacts with further portfolio growth.

Takeaway

In conclusion, I rate OCCI as a buy for the moment as I believe the fund will ultimately benefit from interest rate cuts. While there may be some impacts to net investment income, a lower interest rate environment will ultimately increase the quality of underlying assets by providing a bit of relief on the cost of debt maintenance. Historically, higher interest rates have translated to higher defaults so a lower interest rate should also decrease the likelihood of defaults. OCCI has shared a clear inverse relationship to the federal funds rate so we may also see price increases when rates are cut. The distribution is currently covered by NII at a large cushion of safety so there are no worries about a distribution cut at the moment.