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This article is an update to a previous Oxford Square Capital (NASDAQ:OXSQ) article returning to the chronic issue of Oxford’s underlying investment strategy in collateralized loan obligations (“CLOs”). In review, Oxford Square Capital is a business development company (“BDC”) labeled investment firm that invests in loans and CLO investments. Since COVID-19, the stock has seen a dramatic 45% decline in its stock price from $6.21 to $3.33. These declines follow the 35% declines in net asset value per share (“NAVPS”) for the company from $5.12 at the end of 2019 fiscal year to $3.32 in the first fiscal quarter of 2020. The company has also been further diluting shareholders’ value by issuing more shares over the last two years.
The company’s 35% decline in NAVPS is largely attributed to the declines in the investment portfolio; in particular, the declines in the value of its CLO holdings. In the company’s 10K 2019 released in January, the company valued the CLO’s investments at $120M, a $77M markdown from the reported cost of $197M. At the time, the company had about $379M in investments and cash, which has since declined to $269M in the most recent quarter. In the company’s most recent quarter, Q1 2020, it valued its CLO equity investments at a fair value of $73M, which represents a $122M markdown from the original reported cost of $195M.
The firm has seen its CLO investments decline by 40% in value since the beginning of the year and further declines are expected. This acceleration in the decline of the CLOs follows a trend that was present even before the pandemic hit and was highlighted in a previous article. The outlook ahead under the current economic pressures appears dim for Oxford.
Moody’s CLO Market Outlook Doesn’t Bode well for Oxford Square Capital
Moody’s has recently highlighted in a few news releases and compilation reports in June issues with and downgrades of CLOs. Of recent CLOs to be considered for downgrades by Moody’s was a CLO by the name of Nassau 2019-I Ltd. on Oxford’s balance sheet. This CLO on Oxford’s balance sheet was marked down from $19.5M to $12M in the last quarterly report. Nassau 2019-I Ltd. is potentially 5-10% of the investment portfolio value depending on portfolio fluctuations. Another larger CLO on the balance sheet, Sound Point CLO XVI, Ltd. was marked down from a cost of $40M to $14.5M and is on a Moody’s watch list to potentially get downgraded as well. These two CLOs represent two of the top 10 investments by size in Oxford’s investment portfolio.
It is important to understand that all 27 CLO equities held by Oxford have been marked down by significant margins, resulting in hundreds of millions of dollars in unrealized losses in the past year. The decline in this area and overall poor returns for investors over the years definitely bring to question why the company persists in its CLO strategy.
Moody’s CLO Report
The above graph highlights the significant rise expected by Moody’s in defaults in the coming months that will likely have an adverse impact on the Global and US debt markets and, thus, the US CLO market. Investors need to pay attention to other BDCs in the CLO space such as FS KKR (FSK), Owl Rock Capital Corp. (ORCC) and Barings BDC (BBDC), Bain Capital Specialty Finance Inc. (BCSF) who have made investments or funds dedicated to CLOs.
When investing in BDCs, investors need to be wary of BDCs with private equity and investment firm ties because many times the private equity firms that generate the supply of M&A activity that creates the loans for CLOs also end up managing the CLOs through their subsidiary LLCs or partnered BDCs. This structure of financial operations can potentially lead to BDCs’ balance sheets being treated as garbage bins for private equity firms whose deals that have gone south are packaged together in high yield CLOs and resold. This leaves the door open for the BDCs under the private equity management firms’ advisors to then slowly let the CLOs depreciate on their balance sheets destroying NAV for public investors while collecting the dividends and management fees required of BDCs.
On reviewing the CLOs in Oxford’s portfolio, one will note the slow decline of quality for its CLOs over the previous years. The Sound Point’s CLO, for instance, has declined from Aaa to Ba3. This follows a trend in the CLO market of declining quality in loans as low borrowing rates have extended liquidity and encouraged extraordinary deals.
The Atlantic’s Recent Article May Bring More Scrutiny to the CLO Industry
The recent Atlantic article titled “The Looming Bank Collapse: The US Financial System could be on the cusp of calamity. This time, we might not be able to save it”, may be on readers’ minds. The article discussed the issues of CLOs and their similarities with their CDO cousins that caused the 2008 financial crisis. The article discussed the dangers of banks owning CLOs, even though, in comparison to their balance sheets, CLOs are a very small percentage. The article highlighted Wells Fargo (WFC) which has about $1T in assets but about $30B in CLOs. The negligible risk of CLOs to Wells Fargo’s balance sheet should be obvious to investors as well as the hyped-up nature of the Atlantic’s assessment of the potential 2008 like impact of CLOs on the banks. However, for companies like Oxford where CLOs represent 40-50% of the investment portfolio, investors need to be wary of issues in the CLO market. The recent pandemic and uncertain environment are cause for rethinking CLO exposure in one’s portfolio.
Even though the Fed is currently acting as a backstop for corporate bonds by buying corporate bonds, and corporate debt markets are bringing about “equity-like returns“, it would be unwise to think that the Fed will forever support companies and corporate debt in this fashion. It should be noted, however, that the recent goodwill and forgiveness programs that COVID-19 has fostered around the world and in the US may protect the corporate bond and, thus, CLO markets from default in the near future.
Oxford Square Capital – Conclusion
In review, a collateralized loan obligation (“CLO”) is a group of packaged corporate loan offerings bundled as a financial instrument that is then divided up and sold. In some instances, CLOs can provide an investor or an investment firm with a diversified financial instrument that can reduce their unsystematic risk in middle market loans in a similar way that ETFs do for equity securities. However, the commodification of CLOs, combined with low-interest rates and Fed backing of the broader corporate loan market, has led to the neglect of the real fundamental value underlying the loans with respect to the assets and the cash flows.
With the world’s current pandemic driving businesses to insolvency and default rates expected to increase in the coming months, CLOs are definitely at risk. The defaults in the corporate debt markets will directly impact the value of the CLOs that the BDC companies, banks, and investment firms have created and now own. Oxford Square Capital will not be an exception. The company’s CLO portfolio has declined for years and is likely to continue to do so at the accelerated rates due to the pandemic.
The future declines expected in the investment portfolio from CLOs will then negatively impact the NAVPS and thus market price of the stock. With the stock now trading at 1.0 price/NAVPS, it is trading at a premium to its foreseeable NAV declines caused by its CLO exposure. Investors would be wise to get out of Oxford and start checking all of their BDC, bank and investment firm investments for CLO exposures.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The content of this post is not meant as investment advice as it is the expressed opinion of the author. The numbers and statistics were developed using public information from involved companies and may as all analyst work contain errors. Any decisions or actions made by readers or actors of this article are the sole responsibility of the readers or actors themselves and have no legal or financial responsibility or bearing on the author.