Corporate defaults are still near historic lows, but some investors in collateralized loan obligations are preparing for the inevitable.
Eagle Point Credit Co. and Oxford Lane Capital are both closed-end investment funds that focus on the riskiest securities issued by collateralized loan obligations, and so are highly exposed to potential defaults on leveraged loans. And both are gearing up for an eventual turn in the corporate credit cycle.
"We do agree it’s a when not an if,” Eagle Point CEO Thomas Majewski told analysts on a conference call Tuesday. The firm has over $2.3 billion in assets under management in 70 CLOs, primarily in the "equity," or most subordinate tranches of these deals.
Oxford Lane Capital CEO Jonathan Cohen expressed a similar view on a conference call held last week. “I'm not sure we're at the beginning of the end or the end of the beginning,” he said. “But we are certainly closer to the end.”
Eagle Point and Oxford Lane have something else in common: Rather than take a defensive stance, both are taking steps to stay invested in the leveraged loan market for as long as possible. They are either buying stakes in CLOs with extended reinvestment periods or, in the case of CLOs in which they have a controlling interest, are voting to extend the reinvestment periods. The idea is that managers of deals that can be actively managed for longer will be in the best position to pick up troubled loans on the cheap.
This is unlikely to happen soon. The trailing 12-month U.S. leveraged loan default rate finished July at 2.2%, according to Moody's Investors Service. That was down from 2.4% in June but up from 1.5% in July 2017.
Still, there are some signs that the credit cycle is turning. For a long time, strong demand allowed speculative-grade companies have been reprice outstanding debt at lower interest rates, lowering their funding costs. But repricings in the $1 trillion-plus leveraged loan market have all but dried up, with none occurring during July, Majewski noted on Eagle Point's conference call.
In addition, the percentage of loans trading above par on the JPMorgan Leveraged Loan Index has fallen to 46% from the 70% level in May.
In the second quarter, Eagle Point reset the terms of eight CLOs for which it has controlling interest. (Unlike refinancings in which managers or equity holders seek to lower payment rates to investors, resets typically are completed to extend reinvestment and non-call periods of deals about to start amortizing.)
So far in July and August, it has reset two further deals, bringing the total number of resets to 18 since January 2017.
“The No. 1 thing we’re working on in our portfolio is to buy as much reinvestment period as possible,” Majewski said.
By lengthening the reinvestment period of the portfolio, Eagle Point is hoping that when “that day of credit dislocation occurs, there will be a commensurate amount or hopefully even greater amount of price volatility,” Majewski said.
Marketwide, the $74 billion in reset CLO volume in the first half of the year matched the estimated $74 billion in new CLO issuance, Majewski said. “CLO equity remains reasonably well-bid despite the liability widening as spread compression has subsided,” he said. “We continue to have a robust reset pipeline and expect to direct additional resets in the second half of 2018.”
In addition to resets, Eagle Point has stepped up investments in new-issue CLOs and warehouse accumulation facilities that will feed upcoming primary deals — activity that depleted its June 30 capital reserves to $2.8 million from $8.3 million at the beginning of the quarter.
Oxford Lane boosted its investments in CLO equity by $45.8 million (new investments net of sales and repayments of existing CLO holdings) in the second quarter. It also extended
Cohen said Oxford Lane will focus on building out longer reinvestment periods for its CLO equity holdings. Because of the “long-term, relatively low-cost leverage facilities” the firm has in place to acquire the positions, he said, Oxford Lane’s CLO stakes will be “well positioned to perform during an economic dislocation or a widening spread environment.”
In addition to lining up buying opportunities, Eagle Point is also adjusting its balance sheet obligations to prepare for a down cycle. In the second quarter, the company also refinanced over $67 million in bonds in which it not only shaved its rate by more than 31 basis points to 6.6875%, but also extended the weighted average maturity of its preferred stock and unsecured notes outstanding by another two years.
