Eagle Point Credit Q1 2023 Earnings Call Transcript

Quartr
Provided by Quartr
May 23, 2023

There are 6 speakers on the call.

Operator

Greetings. Welcome to Eagle Point Credit Company Incorporated First Quarter 2023 Financial Results Call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation. Please note this conference is being recorded.

Operator

I will now turn the conference over to Garrett Edson of ICR. Thank you. You may begin.

Speaker 1

Thank you, Sherry, and good morning. By now, everyone should have access to our earnings announcement and investor presentation, which was released prior to this call, which may also be found on our website at Before we begin our formal remarks, we need to remind everyone that the matters discussed on this call include forward looking statements or projected financial information that involve risks and uncertainties that may cause the company's actual results to differ materially from those projected in such forward looking statements and projected financial information. For further information on factors that could impact the company and the statements and projections contained herein, please refer to the company's filings with the Securities and Exchange Commission. Each forward looking statement and projection of financial information made during this call is based on information available to us as of the date of this call. We disclaim any obligation Earlier today, we filed our Q1 2023 financial statements and our Q1 investor presentation with the Securities and Exchange Commission.

Speaker 1

Financial statements and our Q1 investor Presentation are also available within the Investor Relations section of the company's website. Financial statements can be found by following the Financial Statements and Reports link and the investor presentation can be followed by following the Presentations and Events link. I would now like to introduce Tom Majewski, Chief Executive Officer of Eagle Point Credit

Speaker 2

Thank you, Garrett, and welcome everyone to Eagle Point Credit Company's Q1 earnings call. If you haven't done so already, we invite you to download our investor presentation from our website, which provides additional information about the company and our portfolio. The company had a very strong start to 2023. Our portfolio generated solid cash flows while we maintained a stable NAV. Despite the financial doom and gloom prognosticated by many over the past year, I think of all the headlines you've read even in the last quarter, our portfolio of CLO equity has done exactly what it was designed to do, generates solid recurring cash flows for the benefit of our investors.

Speaker 2

Indeed, for the 12 months ended March 31, Our portfolio generated $3.40 per share of recurring cash flow. Even better, our recurring cash flow in April 2023 exceeded the total of our Q1 recurring cash flow by 22%. While we continue to live in uncertain economic times, Our portfolio of CLO equity was designed for periods like these. As of quarter end, our CLO equity portfolio had a weighted average remaining reinvestment period 2.9 years. With roughly 4% of the loan market prepaying at par during the quarter and an average loan price their underlying portfolios.

Speaker 2

For the Q1, our net investment income totaled $0.34 per common share before $0.02 per share of realized losses. We continue to actively manage our portfolio and we deployed $55,300,000 of net Capital into new portfolio investments during the quarter. We received recurring cash flows from our portfolio in the Q1 of $42,300,000 or $0.74 per common share, exceeding our regular distribution, regular common distribution and total by $0.10 per share. As in the Q4, Q1 cash flows were somewhat impacted by the mismatch between 1 month and 3 month LIBOR and SOFR. However, given the compression between 1 month and 3 month rates over the past few months, we saw a significant increase in recurring cash flows in April to over $51,000,000 in total.

Speaker 2

We also paid a special distribution of $0.50 per common share in January of 2023, inclusive of that special distribution, prior special distributions and other distributions we've paid Through April 30, we've now delivered $18.71 per share in cash distributions to our common stockholders since our IPO. NAV per share ended the Q1 at $9.10 Since the end of the quarter, we estimate are now at April month end to be between $8.83 $8.93 a modest decline from where it stood on March 31. We also continue to prudently raise capital through our at the market program and issued over 2,600,000 common shares at a premium to NAV, generating NAV accretion of about $0.05 per common share. These sales generated net proceeds of over $27,000,000 during the Q1. All of our financing remains fixed rate and is unsecured and this gives us protection in a rising rate environment.

Speaker 2

Importantly, we have no financing maturities prior to April 2028. In addition to our solid Q1 performance, On May 11, we declared regular monthly common distributions for the Q3 of $0.14 per share and an additional variable supplemental distribution of $0.02 per common share per month, which is related to our 2022 spillover income. Management currently expects to continue monthly variable supplemental distributions through the end of 2023, though the actual timing and amounts of The weighted average effective yield on our CLO equity portfolio was 15.83 percent and that is a slight reduction from 16.23% where it stood at the end of number. However, the new equity we purchased during the Q1 had a weighted average effective yield of 18.6%, which will help bolster the portfolio's strong weighted average effective yield prospectively. As I mentioned, during the quarter, we deployed 55 point $3,000,000 of net capital primarily into secondary CLO equity as well as some CLO debt, some loan accumulation facilities and other investments.

Speaker 2

During the quarter, the secondary market continued to maintain a significant amount of a significant number of attractive investment opportunities for us with a number of investments we made during the quarter having loss adjusted effective yields in excess of 20%. As a result, we took advantage and deployed a material amount of capital on dry powder that we had into new portfolio investments. As of March 31, our CLO equity portfolio's weighted average remaining reinvestment period stood at 2.9 years, which is a modest reduction from the 3.0 years at the end of 2022. So despite the passage of 3 months Through our proactive portfolio management, the reinvestment period on our CLO equity positions was modestly reduced by just about 1 month. We believe this continues to drive the portfolio's outperformance relative to the broader CLO equity market.

Speaker 2

We remain focused on finding to invest in CLO equity with generally longer reinvestment periods, which we believe will give us better ability to further navigate through the current volatility. I would also like to take a moment to highlight Eagle Point Income Company, which trades under the symbol EIC. EIC invests principally in junior CLO debt with a particular focus on CLO BBs. For the Q1, EIC generated net investment income of $0.49 per share, once again exceeding its regular common distributions. EIC has performed very well through the rising rate environment and remains very well positioned to generate strong net investment income over time given the long term performance of CLO Junior Debt.

Speaker 2

We invite you to join EIC's investor call at 11:30 am today also to visit the company's website, eaglepointincomecompany.com to learn more. Overall, we remain quite active in managing our portfolio and continue to keep a After Ken's remarks, I'll take you through the current state of the corporate loan and CLO markets and share our outlook for the remainder of 2023. I'll now turn the call over to Ken.

Speaker 3

Thanks, Tom. For the Q1 of 2023, the company recorded net investment income, net of realized losses of approximately $18,000,000 or $0.32 per share. This compares favorably to NII and realized losses of $0.29 per share in the Q4 of 2022 and NII realized losses of $0.30 per share for the Q1 of 2022. When unrealized portfolio appreciation is included, The company recorded GAAP net income for the Q1 of approximately $20,100,000 or $0.35 per share. This compares to GAAP net income of $0.17 per share in the Q4 of 2022 and a GAAP net loss of $0.53 per share in the Q1 of 2022.

Speaker 3

The company's 1st quarter GAAP net income was comprised of total investment income of $31,900,000 And total net unrealized appreciation on investments of $7,000,000 offset by net unrealized appreciation on certain liabilities Recorded at fair value of $5,200,000 realized capital losses of 1,100,000 Financing costs and operating expenses of $12,100,000 and distributions on the Series D preferred stock of 400,000 The company's asset coverage ratios at March 31 for preferred stock and debt calculated pursuant to Investment Company Act requirements for 2 99% and 443%, respectively. These measures are comfortably above the statutory requirements of 203 100%. Our debt and preferred securities outstanding at quarter end totaled approximately 33% of the company's total assets less current liabilities. This is within our target range of generally operating the company with leverage between 25% to 35% of total assets under normal market conditions. Moving on to our portfolio activity in the Q2 through April 30, the company received recurring cash flows on its investment portfolio of $51,400,000 This is significantly above the $42,300,000 received during the full Q1.

Speaker 3

Note that some of our investments are expected to make payments later in the quarter. As of April 30, we had $45,200,000 of cash available for investment. Management's estimated range of the company's NAV as of April 30 was 8.8 $0.03 to $8.93 per share, reflecting a 2% decrease from March 31. During the Q1, we paid 3 monthly common distributions of $0.14 per share. Subsequently, we have monthly regular distributions of $0.14 per share along with a monthly variable supplemental distribution of $0.02 per share on our common stock for an aggregate common monthly distribution of $0.16 per share through September 2023.

Speaker 3

In addition, the company paid a special distribution of $0.50 per share in January, which represented a portion of the 2022 tax year spillover income. I'll now hand the call back over to Tom.

Speaker 2

Great. Thank you, Ken. Let me take everyone through some thoughts on the loan and CLO markets as well. The Credit Suisse Leveraged Loan Index generated a total return of 3.11 during the Q1, which was a strong start to 2023 despite the challenging environment in March. The index continued its positive momentum through April, showing the resiliency of the asset class in the midst of volatility.

Speaker 2

Notably, while the regional banking crisis in March did impact overall liquidity in the market related to CLOs and securities broadly, and we have not seen much of an impact with regard to actual credit expense. Indeed, loans and CLOs continue to have very little to no exposure to the most of the regional banks in the news. However, given the banking challenged environment and the broader economic environment, we did see 10 leverage loans default during the Q1. Indeed, ECC has exposure to well over 1,000 loans, so just to frame the materiality of that count. But as a result, as of quarter end, The trailing 12 month default rate stood at 1.32 percent, up from the end of 2022, but still well below historical averages.

Speaker 2

Most bank research desks are expecting the default rate to end up around 3% by the end of the year. Despite the increase in defaults, during the quarter, approximately 4% of leveraged loans paid off at par. This provides our CLOs, which are in the reinvestment period, with valuable par dollars to reinvest in today's discounted loan market to offset the losses from defaults and other distressed credits. With a significant share of high quality issuers trading Their loans at discounted prices, PLO collateral managers were well positioned to improve underlying their underlying loan portfolios during the quarter through relative value credit selection in the secondary market. As I noted previously, as well as Given the market conditions, the percentage of loans trading over par continues to be essentially 0 with the Credit Suisse Leveraged Loan Index at a price of 92 point 6.7% recently.

Speaker 2

As a result, repricing in the loan market remains essentially 0. Instead, in fact, we are observing refinancing activity as loan issuers tackle their 2024 2025 maturities. Despite having lower financing spreads in place, loan issuers are extending their maturities by offering lenders higher spreads and new OID on the refinanced loans. This has been accretive to our portfolio's weighted average spread, which in turn increases the yields we receive on our CLO equity portfolio. On a look through basis, the weighted average spread of our CLO's underlying loan portfolios increased 4 basis points at the end of March compared to where it stood at the end of December.

Speaker 2

And this measure has now increased by 9 basis points over the last 12 months. CCC concentrations within our CLOs stood at 4.4% as of March 31, and the percentage of loans trading below 80 within our CLOs is about 6.3%. Our portfolio's weighted average Junior OC cushion was 4.85 percent as of March 31, which gives us significant headroom to withstand downgrades and potential credit losses. Indeed, our junior OC cushion is significantly above the 3.9% seen more broadly in the CLO market. This is not by accident, it's by design.

Speaker 2

In the CLO market, we actually saw $34,000,000,000 of new issuance during the Q1. We believe a significant majority of this volume was backed by captive CLO funds, which are generally far less return sensitive than an economic actor like ECC. Reset and refinancing activity also remains at essentially 0 due to most current CLO debt pricings being in the money. While the market gives The in the money nature of our CLOs financing some credit, we believe the market doesn't give it full credit and that it represents hidden value embedded in our portfolio. We believe our weighted average CLO AAA spread of 119 basis points is roughly 74 basis points in the money today.

Speaker 2

As we have noted, it is an environment of loan price volatility where we believe CLO structures and CLO equity in particular are set up well to buy loans at discounts to par with a very stable long term financing structure using par paydowns from other loans and have the ability to outperform the broader corporate debt markets over the medium term as they have done multiple times in the past. To sum up, we generated net investment income for the Q1 of $0.34 per weighted average common share. Our portfolio saw a modest increase in NAV during the quarter. We saw a significant increase in cash flows in April, which bodes well moving forward for our portfolio. We also remain very active in the quarter in terms of sourcing and deploying investments at attractive yields, particularly in the secondary market where most of our We continued our existing regular monthly common distributions and variable supplemental common distributions through April of 2023.

Speaker 2

We strengthened our liquidity position during the quarter, generating additional $0.05 of NAV accretion through our ATM program, And we continue to remain 100 percent fixed rate financing completely unsecured with no maturities prior to April of 2028, which gives us protection from any further rising rates and attractive cost of capital for many, many years to come. We believe the company's investment portfolio is in really good shape and the weighted average remaining period, strong OC cushion and increasing cash flows are all evidence of that. We remain pleased to return extra cash to our investors in the form of special or supplemental distributions and we'll remain opportunistic and proactive as we manage our portfolio with a long term mindset as we always have. We thank you for your time and interest in Eagle Point. Ken, we'll now open the call to your questions.

Operator

Our first question is from Mickey Schleien with Ladenburg Thalmann. Please proceed.

Speaker 4

Good morning, Tom and Ken. Hope you're well. Tom, about a quarter of your CLO equity portfolio is beyond its Reinvestment period and I think about another 15% has less than a half a year left. And as you mentioned, since AAA spreads are very wide. The CLO primary market is very slow.

Speaker 4

So the opportunity to refinance And reset these as very limited. So with that in mind, how do you see the funds cash flows developing as these CLOs exit the reinvestment period and start to unwind and pay off their AAAs, which are their cheapest debt?

Speaker 2

Good question. You cited the number 25%?

Speaker 4

This is based off of the last SOI. We haven't seen this quarter's, but about a quarter of the previous SOI Was beyond the reinvestment period and around 15% had less than half a year left.

Speaker 2

Yes. And are you basing that on the Par value or the market value, just so I can understand?

Speaker 4

I just counted the number of positions.

Speaker 2

Got it. Okay. I haven't done the math. I would and I would we can do that as a follow-up here. I would have a strong suspicion, the dollar amount of CLOs outside the reinvestment period is lower than 25%.

Speaker 2

That could very well be on the accounts basis, but not the dollar basis. Just thinking about Other investments going into the portfolio because once we're outside the reinvestment period, we counted as 0 in that weighted average. So if we're at 2.9, It's going to be a smaller portion based on market value. And typically securities with lower market values Are generating less cash flow. So while any CLO outside of its reinvestment period as a general rule, you'd From being outside the reinvestment period, my expectation is that it's relatively light in terms of the percentage.

Speaker 2

In our investor deck and we did publish one this morning, but I know it's tough to get through it before everything before the call. We actually show the cash received on Page 26 of the deck. Let's see, it looks like 25, 26 shows the cash received position by position. Maybe as a follow-up to look into those numbers and look at the cash we received and look how much of it comes from CLOs that are outside the reinvestment period versus those that are in. And my expectation is you'd see it's a very different ratio of those that are in versus out.

Speaker 4

Okay. I'll follow-up with Ken on that. Couple more questions, Tom. In the sort of 2015 minutei credit Cycle the CLO equity portfolios mark declined to about 75% of costs and then it rebounded almost to par in about a year. And same sort of thing happened during the COVID cycle, except it fell to around 50% of cost and then rebounded to par in mid-twenty 21.

Speaker 4

In the current cycle, it's down to around 75% of cost, which I think may reflect the outlook for cash flows or the uncertainty about the outlook for cash flows. So when you think about the Fed potentially ending its monetary tightening, how do you see the market valuing CLO Equity going forward.

Speaker 2

Yes, there's good question. There's Any number of possibilities. On one hand, if let's say the Fed were to start cutting rates aggressively, not that and that's not a prediction, just a theoretic, That might suggest the economy is in a lot of trouble and maybe that portends for additional defaults. At the same time, if they keep increasing rates, maybe that It pretends for companies have a hard time paying their debt service. So I could kind of talking negatively both ways there on one hand.

Speaker 2

The flip side, assuming we're maybe closer to the top, but not going down too far, maybe we go up or down a little bit from here. What we see is by and large, we've out of thousands of issuers, what do we let me just flip back here. We have exposure to 1872 avogors, and in the U. S, 10 of those 10 companies defaulted in the loan market. So, a teeny percent of the count of our obligors, that's a count basis, not a percentage basis.

Speaker 2

But to frame the actual credit expense occurring, Not too, too bad in the overall scheme of things, obviously, like 0 defaults, but that's improbable. So where we look, The best news out there is by and large the top line and bottom line of Low investment grade companies that report publicly, and this is per S and P or LCD data, top line and bottom line are still growing as of the latest data that I've seen. And while we always like revenue to grow at 20%, in many cases, it's growing in the high single digits to low to mid teens on a year over year basis. And that gives companies at least some degree of debate why that is, it's inflation, it's this, it's that, Companies are growing in general. These are in many cases levered buyouts oriented towards growth.

Speaker 2

My expectation is companies will Even a 3% default, that means 97% keep paying, 1st off, an increase in defaults would push prices down, which could in the near term hurt CLO equity values. And that when the market values a piece of CLO equity, It's a combination of looking at the future cash flows and looking at the net asset value or what's the liquidation value if you were to just unwind a CLO. When you create a new CLO, it's much more an NPV analysis. When you're at the end of the reinvestment period, it's much more of a liquidation analysis and the right answer somewhere in between. Our expectation is over time, CLO values will go back up.

Speaker 2

And in my opinion, they're depressed More than the risks warrant, but the market is the market. It's hard to predict what will happen definitively In the coming months, prices may move up or down. I think a lot of the pain is behind us. That's but that's my best Estimate at this point, I can't say that definitively. But what I do know is just as we saw during COVID, Our portfolio had a much lower payment interruption rate than the broader market, and our portfolio was set up with more OC cushion than the broader market And a much longer weighted average reinvestment period than many CLOs on average, which we think will give us the perseverance to continue generating strong cash flows, even if we see defaults pick up.

Speaker 4

That's really helpful, Tom, and I agree with those sentiments. And you mentioned defaults and I do see that the portfolio's CCC bucket actually declined, which is a very good trend. And how do you view the ratings agency's outlook on leverage loan defaults today versus maybe a couple of quarters ago? It just feels like things are not as dire as we were maybe thinking in the middle of last year going into this year. And Yes.

Speaker 4

I'm just curious whether you think the pressure from downgrades is easing.

Speaker 2

No one's ever got into a credit cycle saying, oh, it's not going to be that bad this time. So every cycle, oh, it's going to be terrible, it's going to be doom and gloom, there There's no bottom. And at heart here, most of the folks we do business with are credit folks. I agree with your broad sentiment that It's in my expectation not going to be as bad as many of the naysayers say. The biggest thing or a big thing out there, the percent of loans trading below 80 in our portfolio, I gave you that stat.

Speaker 2

Let me go back and look at it. That is up a little bit. I forgot what it was, but we mentioned it earlier. Let's see, here we go. We have 6.3% of our loans trading below 80.

Speaker 2

CCC is at 4.4%. That means assuming all this, There's a 1.9% difference between those two measures assuming all the CCCs are trading below 80. That's Not necessarily accurate, but let's make that the assumption. There's another 1.9% of loans that are below 80% that are not yet trading at rated CCC. Why that is, who knows?

Speaker 2

I don't usually the market's ahead of the agencies on these things. So the combination of the collage of those two things is really what to look at when trying to measure the potential risk in the portfolio. The offset to that is what's the payment rate and what's the price of loans. And what we saw last year, in general was significant par build across many of our CLOs. If anything, they're maybe giving back a little par so far this year, but I'm happy to see them do that as they're trimming tails and trying to minimize risk.

Speaker 2

Hence, you the CCC bucket come down on aggregate. But again to talk about that, if our CCC basket is 4.4% And our junior OC cushion is 4.85%. Typically in a CLO, there's some haircuts on the Numerator of the OC test once CCCs get above 7.5%. Even if we saw in our average CLO, Even if we saw CCC double, that wouldn't interrupt, that wouldn't fail the OC test on our typical CLO. Probably even if we saw them triple, I'm holding all of us constant, it likely wouldn't trip that junior OC test on the representative average CLO.

Speaker 2

So we've got a ton of cushion in the space. We have again the broader we're 4.85% on the Junior OC cushion, The broader market is at 3.9 percent and this is by design how we structure our portfolios to give us More stability during choppy markets. At the extreme, if the test were to fail, the consequences are great, but it's not catastrophic. The Consequences is suspending equity distributions at a CLO and redeploying that money to either buy new loans or De lever your AAAs. Importantly, OC tests only matter 4 minutes per year.

Speaker 2

I used to say 4 days a year, but it's really just 4 minutes. It's 5 p. M. On the quarterly determination date. It's interesting at all times in my opinion, But the only time it has any economic substance is at 5 p.

Speaker 2

M, proverbial 5 p. M. On the day of determination. So Even if you went off sides on that, CLO collateral managers then have some runway to getting some time typically from when downgrades were to get back on side. So I agree with your sentiment.

Speaker 2

The headline are typically always worse than the news and credit. Credit people are by definition pessimists, Which is what we're supposed to be. I think when you see companies growing top line revenue on average the way we're seeing, That's usually not a big harbinger of default.

Speaker 4

That's really insightful and very helpful, Tom. I appreciate your time this morning. Thank you.

Speaker 2

Thanks so much, Mickey.

Operator

Our next question is from Paul Johnson with KBW. Please proceed.

Speaker 5

Yes, good morning. Thanks for taking my question. I know we discuss this fairly frequently, but I'm just curious in terms of how the dynamic, I guess, played out this quarter between asset repricing on the loans, the underlying loans in the portfolio versus the liabilities and whether that was sort of at play here, I guess, this quarter. Just obviously, kind of looking at The income quarter over quarter relatively flat versus the fairly significant growth you guys had and Strong cash flows this quarter that you mentioned that came in. So any sort of color, I Yes, on that relationship and how that generally works for you and maybe how you'd expect that to kind of play out for the year if possible?

Speaker 2

Sure. Let's see. Let's hit on a few things there. So changes in CLO debt spreads and loan spreads, we'll start there. On loan spreads, it's coming up right now, which is good.

Speaker 2

If you were to go back and find transcripts From our 2018 calls, we would have been lamenting that while defaults were low, loan spreads were getting tighter and tighter. And in many cases, loans are trading above par, companies could come back and refinance at a tighter spread. Today, it's the opposite. Companies are refinancing their 2023 maturities, which might have a hypothetical here, might have a 300 spread, But they want to get rid of the 'twenty three or 'twenty or certainly 'twenty three or even 'twenty four or 'twenty five maturity and they're refinancing at a wider spread. And this is not and if you're a treasurer or a CFO at a levered borrower, you're sitting there saying, well, I don't want this debt, long term debt to be in the current portion of my balance sheet.

Speaker 2

The window is open. It seems to have to pay a higher rate and offer Some OID as well to these investors, but I'd rather do that than have investors ask me why the long term debt is due within a year. So it's on one hand, no one would rationally refinance wider. And if you're facing a medium term debt maturity, it makes sense to refinance wider just to get yourself some runway. So we love that.

Speaker 2

This is the opposite of what we used to call spread compression. This is spread expansion. So we're thrilled to see that. I suspect that trend will continue as companies keep tackling their 24, 2025 and soon there are 26 maturities. The window is open.

Speaker 2

It's been a choppy couple of years for in the credit markets. If you can print and extend the marginal I'm spending someone else's money here, but the marginal 100 basis points on part of your debt financing when you're trying to grow your business 20 percent top line versus taking the risk off the table of can't refinance later makes a ton of sense. So that's great. We hope that trend continues. It feels like it will.

Speaker 2

Now CLO debt is unchanged in terms of the spreads. One of the advantages mindful at EIC, we'll talk the other way about this, but as and for ECC, We're basically short the CLO debt at a fixed spread. And we have an option typically as the majority investor in the CLO sort of a protective right to declare and direct a refinancing of the CLO if it makes sense. But I think I mentioned our weighted average AAA spread was 119 basis Points over LIBOR. The generic kind of AAA level right now in the market is kind of 195, the tights are 175.

Speaker 2

So our debt is very, very much in the money. And as an equity investor, you see a low debt, it's kind of Heads, I win, tails you lose, if spreads tighten, we'll refinance you tighter and if spreads widen, we won't. So whereas maybe 18 months ago, it was kind of refi and reset mania here at Eagle Point, I couldn't tell you the last time we did one of those Because right now our debt is so in the money. So we're fortunate and our maturities are longer than our loans, so we don't have any refinancing need in our CLO portfolio. So the good news, loans are shorter and they're refinancing wider right now.

Speaker 2

So the good news, loans are shorter and they're refinancing wider right now. Our spreads are set in stone. So that much is good. In terms of earnings power for the company, obviously, it's very difficult to forecast earnings. We like to make things as high as possible.

Speaker 2

That much I can assure you. The pickup in cash flow in April versus the prior quarter or 2 was driven by just a kind of a natural correction of a basis between 1 month and 3 month LIBOR or 1 month and 3 month SOFR. While CLO debt all pays off of 3 month rates, LIBOR or SOFR, loans can pay 1 month, 3 months, 6 months or even off a prime, Prime minus typically, but it's an oddity in the loan market that the borrower can choose their rate. And when rates were moving up very, very quickly and the short end of the yield curve was steep, what folks did was focus on, If you were a corporate treasurer and it was a 25 basis points difference in 1 month versus 3 month rates, you pay the 1 month rate. Our CLO guys had to keep paying 3 months to our lenders and that caused a little bit of mismatch.

Speaker 2

As the short end of the yield curve and again this is the 1 to 3 month There's nothing to do with 5 years, 10 years, 30 year treasuries. This is the 1 to 3 month portion of the yield curve. As that has kind of normalized and flattened, we're seeing the difference even go to 1 month LIBOR being very modest and more companies in many cases going back to So that's good. We like more income, not less. And then how does that translate to earnings?

Speaker 2

Broadly, when we forecast effective yields, it's based on the cash flows on the loans versus the cost of the debt. If we get more cash in than we modeled, which is what happened on many investments in April, That has the effect of pushing down the amortized cost. Let's say we have an investment with a 15% loss adjusted effective yield And we expected to get a certain amount of cash. If we got a greater amount of cash, that excess is treated as a return of capital in our accounting system, and it was very standard accounting. From there, when we reforecast expected yield for the next quarter, All else equal, and obviously, that's a big statement, we have a lower basis from which we're forecasting those cash flows.

Speaker 2

So if the cash flow stays just as predicted them, but now we have a lower basis. All else equal, the effective yield goes up because we get that same cash off a lower basis. So if everything else stays the same and we got that bonus or that normalized more normalized long term distribution in April, that would suggest that Effective yields could go up prospectively. Obviously, there's a multitude of other things that could impact it, but holding all else constant, that would drive effective yield up, which would Therefore, it likely drive earnings higher. So, a lot of factors go into that, but that's the broad piece.

Speaker 2

It's always a good scenario when we're getting more cash flow from our

Speaker 5

Thanks, Tom. Appreciate that. A lot in there, but very helpful answer, Helpful insight as always. Basically just 1 or 2 more questions. I mean on that sort of same topic, And what would you say, I guess, in terms of the CLO investor asset class?

Speaker 5

And I guess it's this Kind of relationship with rates in general, I mean, is the risk free rate has gone higher last year? I mean, I understand a lot of The decline in CLO activity this year may be somewhat supply constraint driven. But what would you say, I guess, About the future demand of the CLO asset class, just with higher rates in general And just the ability obviously, maybe this answer is a little bit different between the CLO debt versus equity investors, but Does that have any impact on CLO formation and obviously has an impact on CLO spreads? Just any sort of insight there would also be helpful.

Speaker 2

Sure. Let me address. There's a couple of pieces in there. In my opinion, CLO equity investors Don't really give 2 hoots about rates. We've been working with this asset class when LIBOR was 6%, LIBOR was 0% and kind of everywhere in between.

Speaker 2

And the base case the bankers always show is 14%, give or take. It's not a LIBOR plus type market. And in general, people think of in my opinion, people think of CLO equity relative to equity like returns. And just as people investing in venture capital today demand a higher return than they did a year ago, loss adjusted yield a year ago theoretically. Today, we're putting money at a 18.5% rate loss adjusted yield, give or take, maybe even higher.

Speaker 2

And We could certainly some are over 20%, in fact. We could focus even higher and higher, but we're focused on moving up in quality in general in these markets. So it's in CLO equity, the nice thing is the floating rates, asset and liabilities other than that slight mismatch on 1 month to 3 month largely cancels itself out. And it's just simply what sort of rate do folks care on. So for CLO equity, it's more about just general risk tolerance than base rates.

Speaker 2

Very few people think of it as LIBOR plus Then moving over to CLO Debt, that becomes more interesting. CLO BBs were as little as 500 over, not 5 years ago, give or take. When base rates were close to 0, all of a sudden CLO debt, CLO BBs might have been 5.5% investment. And get treasury is nearly at 5.5% today. So that's obviously changed.

Speaker 2

When you look at CLOBBs with on a spot rate of 5%, Often trading at 8.5 percent with a spread of 8.50 percent or DM of 8.50 percent, all of a sudden you're looking at kind of a 13% to 14% Current yield on those and many of those bonds are trading in the 80s. And so when we quote these DMs or discount margins, That's on a yield to or DM to worst basis assuming the CLOs never get called. And when we look at CLOBB today, We kind of view the assuming the bonds pay off and you underwrite them well, your downside to maturities in the 13, 14 range. But If you've got 10 to 20 points of convexity on your bond, if spreads normalize and spreads tighten or that CLO gets called sooner, all of a sudden you could be looking at a 20% return opportunity as well. So that's a pretty interesting investment as well.

Speaker 2

Even at CLOAAA's broadly they're at SOFR +200 today give or take 195. That's about a 7% return investment. That's, in my opinion, a very attractive investment unto itself for an asset that's never had a credit loss in the history, the nearly 30 year history of the asset class. So that's pretty attractive. In terms of CLO formation, the real challenge in my opinion is the gap between CLO AAA spreads And loan spreads is out of whack right now.

Speaker 2

And CLO, you have AAA guys that they're demanding 195 over on average and then the rest of the stack commensurately wider, that just pencils to a typically too low yield for CLO equity in my opinion. If we're able to buy high quality paper at 18 and change in the secondary market, in many cases, new issue CLOs Pencil out to around 10% today and there's about an 800 basis point difference or greater, secondary versus primary. So the big challenge in the market is that there's not enough CLO AAA investors in my opinion. It's a great investment. Now you could have a different view on rates.

Speaker 2

Maybe you think rates are coming down, in which case you'd be better off buying But here you're just able with CLO debt, you're able to take rate duration off the table. The largest constraint to CLO Formation, in my opinion, is the availability of AAA Capital. And indeed, of the CLOs that were issued, there were $34,000,000,000 in In our opinion, based on a review of the issuances, the vast majority of those were taken by captive CLO funds, where the collateral manager is the one who decides when the equity invests, not a profit motivated third party investor like ourselves. Why in the world you would buy a new investment from a collateral manager at 10%, when you can get the same thing in the secondary market at 18 Percent yields is beyond me, but those exist and indeed a fair number of we believe the majority The volume in the Q1 was driven by those captive funds. We get a couple more AAA investors on.

Speaker 2

We get some more normalization. I think we'd see a pickup in issuance. But for ECC, what we see is there's a ton of opportunity in the secondary market. April, Over $500,000,000 of notional, maybe even close to $1,000,000,000 I forget the number, it was so big of CLO equity available on BWIC in the secondary market. Not all of that traded and obviously it's trades at less than par, but still measured in the 100 of 1,000,000 dollars of investment opportunity.

Speaker 2

So we like that and 90% of our focus right now is in that market.

Speaker 5

Thanks again, Tom. Appreciate the answers and that's all for me.

Speaker 2

Great. Thanks. Long answer. Appreciate your time, Paul.

Operator

And that concludes our question and answer session. I would like I'll turn the call back over to Tom for closing comments.

Speaker 2

Great. Thanks so much everyone for joining our call today. Ken and I appreciate your

Operator

Thank you. This does conclude today's conference. You may disconnect at this time and thank you for your participation.

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Earnings Conference Call
Eagle Point Credit Q1 2023
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