Tag Archives: business

Oxford Lane Capital And Eagle Point Keep Churning Out The Cash, While High Yield Market Jitters Drag Down NAVs

Summary As high yield bond and corporate loan markets continue to be hammered by nervous investors, funds like OXLC and ECC have seen their NAVs drop even more. This is a natural result of their leverage, but essentially is irrelevant to their ability to generate cash flow and make their dividend payments. These are tough vehicles for some retail investors to understand and appreciate, but offer impressive income potential to those willing to make the effort. As the proverbial blood continues to run in the streets of the high yield bond and leveraged loan markets (because of a range of fears related to the Fed increasing rates, the world economy slump, etc.) the non-investment grade companies that comprise those markets continue to go about their business, making their interest and principal payments. This translates into strong cash flows and high distributions for Oxford Lane Capital Corporation (NASDAQ: OXLC ) and Eagle Point Credit (NYSE: ECC ), the two closed end funds that specialize in buying collateralized loan obligations (“CLO’s”). CLO’s are leveraged, special purpose vehicles that function like “virtual banks,” buying and holding senior, secured floating-rate loans to non-investment grade companies. (This is the same cohort of companies that issues high-yield bonds. But whereas high-yield bonds are unsecured and typically recover only 20-30% in the event of the issuer’s default, senior secured loans have historically recovered 70-80% in the event of default, so the overall credit loss on a portfolio of loans over time is less than half the credit loss on a portfolio of high yield bonds.) Both ECC and OXLC put out quarterly reports yesterday and followed up with investor conference calls this morning. In both cases the messages were similar, that the market for the assets they hold – CLOs and the loans held by CLOs – are way down, the cash flows from those assets continue strong, and the reinvestment opportunities for CLOs in the loan market are very attractive. But the strong income prospects this represents (OXLC yields over 22% and ECC over 14%) are not enough to offset the fears of many closed end fund investors, who remain fixated on the net asset values (NAVs) of both funds. These have dropped in recent months to reflect the depressed markets for their underlying assets. Here is why the NAV of a CLO fund would drop as the market for its underlying assets drops. Suppose the equity in a typical CLO is leveraged 10 times. If the market for the loans held by that CLO drops by 1%, then the mark-to-market or “paper loss” to the equity of the CLO will be 10 times 1%, or 10%. This means that investors should not be surprised to see NAVs of ECC or OXLC fall at about ten times the rate as the drop in market prices in the loan market. None of the drop however, has any relation to the ability of the portfolio to generate the cash needed to pay distributions. Investors who can understand that and be comfortable with it can appreciate the opportunity these funds represent for income investors. But be prepared for a potentially volatile ride in terms of market value, although many of us who have owned the funds for awhile may feel – given the current entry point versus where we got in – that today’s new investors will have a smoother ride than we did.

An Aggressive Allocation Strategy For Young Investors

Summary Using 5 ETFs investors can create a fairly efficient and aggressive equity portfolio. These ETFs are all listed as “commission free” for Schwab accounts and have low expense ratios. The strategy uses 25% international allocations and 75% domestic allocations. To create some bond sensitivity in a pure equity portfolio the allocation to domestic equity REITs is significantly higher. For this article I want to present a fairly aggressive allocation for young investors looking for a simple portfolio. This portfolio would be too aggressive for many older investors, and it even for younger investors that are unable to take the risk of going all in on equity. This portfolio holds precisely zero bonds, and investors would need to be aware of the higher volatility that this portfolio would experience. Holding a portfolio that is devoid of bonds is not a new strategy to me. My personal portfolio (counting investments under my wife’s name) is devoid of bonds with the exception of holding mREITs. The mortgage REITs are essentially a levered and option-embedded bond fund. My mREIT holdings are around 20% of my total portfolio. While the mREITs do represent bonds in a way, they are certainly not reducing the volatility of the portfolio the way that a simple treasury allocation would. The Five ETFs The five ETFs that I would suggest for this portfolio are: SCHE Schwab Emerging Markets ETF SCHC Schwab International Small-Cap Equity ETF SCHF Schwab International Equity ETF SCHH Schwab U.S. REIT ETF SCHD Schwab U.S. Dividend Equity ETF This allocation strategy results in 25% of the equity being invested internationally through the combination of three international funds with the rest of the portfolio being held in domestic investments. The equity REITs in SCHH get a heavier allocation than some investors would feel comfortable using because the equity REITs have some correlation with bonds. In effect, this is allowing the portfolio to import a small amount of bond sensitivity while still maintaining an aggressive all equity allocation. The weights I would use for this kind of portfolio are shown below: Rationale for Allocations – SCHH Since this aggressive strategy is not using bonds, it would be very reasonable to go overweight on either equity REITs or utilities since both have some very material correlation to bonds. Both of these sectors can be used as sources and compete for allocations from investors seeking income. Without bonds, I would want to overweight SCHH. This can be seen in my portfolio allocations as I have been keeping domestic equity REITs around 20 to 25% of my total portfolio. Rationale for Allocations – SCHE, SCHC, SCHF The rationale for the allocations among SCHE, SCHC, and SCHF is fairly simple. I like incorporating a small amount of SCHE for exposure to markets that otherwise would not be present in the portfolio. Currently, SCHE is the only one of these five ETFs that I do not own. By April I will probably have a small position in SCHE. The other four are already present in my portfolio. I feel the emerging markets are more dangerous than the developed markets, so I think SCHE positions should remain smaller than SCHC or SCHF. SCHC is the small-capitalization companies in the developed markets, and the fund keeps growing on me. I think these smaller capitalization companies in the international markets are going to be less efficiently priced than the larger capitalization companies. I expect this to give SCHC a little boost to performance. Even if I’m effectively buying those companies blindly, the position is diversified effectively. SCHF is giving more of what I consider the standard international allocation. The positions are in larger companies that are more established and may be more efficiently priced, however I’m starting to like international markets after several years of poor performance. Out of these three international funds I would expect SCHF to be the least volatile and it has a very low expense ratio for international investment at .08%. To be fair, this list is intentionally restricted to funds with very low expense ratios relative to peers in the space. Rationale for Allocations – SCHD I’ve used SCHD instead of a total or broad market ETF in this example which might surprise some investors. If I’m creating a hypothetical portfolio for a young investor, why wouldn’t I just use the whole market ETFs? The reason for using SCHD is the same reason that I put a heavy weight on equity REITs for the portfolio. This hypothetical portfolio is designed with zero allocation to bonds and SCHD has more defensive sector allocations than broad market ETFs. Perhaps most notable SCHD goes overweight on consumer staples which tend to withstand fierce selloffs in the market. If the portfolio were designed to incorporate more bonds, then I think the appeal of a broad market ETF would increase. Because I started with the assumption of a younger investors that wants to go without bonds, I opted to make the core equity holding a more defensive allocation. Hypothetical Use For an equity heavy strategy like this, dollar cost averaging would be very appealing. In this scenario I would favor rebalancing over just letting the positions sit. For a shorter time frame, I don’t think it would matter much but if the investor was simply going to let the portfolio run for longer than a decade, then I think some rebalancing would be favorable. Commissions Since trading commissions can eat into an investor’s return and my hypothetical young investor is stuck investing less than $10,000 per year, I picked only funds that would be commission free for investors using Schwab. In choosing a brokerage, I think one important consideration is which funds they offer as “commission free”. My only relationship with Schwab is having my personal accounts there. They got my business by offering an attractive list of commission free ETFs and knowing how to handle a solo 401K account. Volatility I ran a regression on this portfolio compared to the S&P 500 using returns since October of 2011. (click to enlarge) Investors should expect that this portfolio would underperform the S&P 500 over the last 4 years if they have been following global markets because international equity significantly underperformed domestic equity. Despite that under performance, it is worth noting that the combined portfolio had an annualized volatility of 12.8% compared to the S&P 500 having an annualized volatility of 13.5%. I believe this reflects an equity portfolio that is intelligent structured to reduce total volatility while offering the potential for significant returns. Conclusion A portfolio like this can be an option for a young investor with a strong enough risk tolerance to run a portfolio that is purely invested in equity. In my opinion, a strategy like this that is focused on ETFs should involve some plan for rebalancing.