Oxford Lane Capital (OXLC) is one of the few ways retail investors can profit from collateralized loan obligations, or high-yield low-risk fixed-income securities. A lot has been written about the company already, with most previous articles focusing on explaining some of the peculiarities of investing in CLOs, and on the company’s cash flows. Something that I haven’t seen is an attempt at estimating the company’s long-term shareholder returns from the underlying yield of its holdings, something that shouldn’t be all that hard for to do.

In this article, I’ll explain why OXLC’s long-term shareholder returns should be equal to the company’s underlying net effective yield, demonstrate how this has been the case for the past four years or so, and estimate future shareholder returns using this same metric. OXCL’s investors should expect 11.2% in total shareholder returns from the company moving forward.

Expected Shareholder Return Calculation

OXLC invests in collateralized loan obligation, or CLOs. CLOs are basically fixed-income securities backed by a portfolio of diversified syndicated loans. CLOs are a complicated asset class, with byzantine accounting standards and hard-to-forecast yields and returns, so I’ll try to keep things as simple as possible in this article. Investors who are interested in some of the more technical details of CLOs can read this article, from Alpha Male here at Seeking Alpha, which I thought was particularly illuminating.

OXLC’s returns, as of those of most investment securities, should follow the following very basic formula:

NAV Returns = Distributions + Capital Appreciation(Depreciation) – Expenses

The above formula is, I believe, pretty self-explanatory. Returns can come from either distributions or capital appreciation, net returns subtract out the fund’s expenses from both of these. Seems simple enough.

Now, distributions and expenses are relatively easy to estimate, capital appreciation or depreciation less so. This is because there are many extremely volatile factors which affect the pricing and value of fixed-income securities, including interest and discount rates. Changes in these two factors, which are relatively frequent, have an outsized impact on CLO NAVs, even if they don’t particularly impact their long-term shareholder returns.

Due to the above, estimating expected capital appreciation and depreciation for CLOs can be extremely difficult. Luckily for us, we don’t actually have to do so. Many CLO investors, including OXLC, calculate something called effective yield, which automatically takes into consideration expected capital appreciation and depreciation. Deloitte gives a particular simple explanation of said metric:

Under this model, investors (as of the purchase date) need to estimate the timing and amount of all future cash inflows from the security using assumptions that were used in determining fair value. The excess of those future cash flows over the initial investment is the accretable yield to be recognized as interest income over the life of the investment using the effective yield method.

(Source: Deloitte)

Simply put, the effective yield is management’s best guess as to the fund’s long-term distributions plus capital appreciation and depreciation. These estimates won’t be all that accurate quarter to quarter, due to the impact of changing interest and discount rates, but should be significantly more accurate in the long-term, as these two factors don’t have a lasting impact on shareholder returns.

Taking into consideration the above, I can say that:

Long-term NAV Returns = Effective Yield – Expenses = Net Effective Yield

A very simple formula and remarkably easy to calculate.

OXLC itself already calculates the effective yield on its investments, and it currently stands at 16.2%.

(Source: OXLC Investor Presentation)

You have to adjust the above figure for the fund’s leverage, which is also provided by the company’s managers:

(Source: OXLC Investor Presentation)

Expenses are also readily available on the company’s latest annual report, and the figures are already adjusted for the fund’s leverage or on a net asset value base:

(Source: OXLC Annual Report)

I can use the above figures to calculate expected returns as follows:

Long-term NAV Returns = 16.2% * 1.48 – 12.8% = 11.2%

OXLC’s investors should expect their long-term returns to be of around 11.2%. These are, I believe, very attractive returns and would make the company an incredibly attractive investment opportunity for investors of all stripes.

These results also imply that the company’s NAV and share price should see reductions of about 8.7% per year, both of which have indeed gone down by just about that since inception:

ChartData by YCharts

Nevertheless, the analysis above is for returns on a NAV basis. Actual shareholder returns might vary if the company’s discount or premium to NAV changes. OXLC currently sports a whopping 31.1% premium to NAV, so there is quite a bit of downside potential on returns if the company were to start trading at more reasonable levels. On the other hand, I’m not sure how informative this figure actually is. As mentioned previously, the company’s NAV is not a particularly informative measure in the short term, it is very possible that the company’s large premium will naturally dissipate in the coming quarters.

ChartData by YCharts

Past Shareholder Returns Analysis

OXLC provides enough information to calculate effective yields and expense ratios for four years or, more specifically, from September 2015 to September 2019. Net effective yields have been a successful predictor of long-term NAV returns, as expected.

(Source: OXLC Annual Reports and Investor Presentations – Chart by author)

As can be seen above, short-term NAV returns, or those for periods of under two years, are basically completely decoupled from the company’s effective yield. NAV returns are simply not very informative for short periods of times. By the three-year mark, NAV returns start to closely track the company’s effective yield, and by the four-year mark the two metrics are close to indistinguishable. As such, I believe that effective yields and expenses are a very close indicator of long-term NAV returns, and that OXLC’s future returns should be very close to the 11.2% previously calculated. As a final point, it seems that OXLC’s current net effective yield is slightly lower than its long-term average, so expect shareholder returns to decrease somewhat.

Price returns are significantly less volatile, almost certainly due to the fact that OXLC’s investors are wise enough to disregard short-term changes on the company’s NAV. Price returns are also slightly stronger than NAV returns, at least for the time period analyzed, as the company’s premium to NAV has widened during the past few years. In my opinion, the company’s premium is unsustainably high and, as such, investors should expect lower shareholder returns moving forward.

Conclusion

OXLC’s investors should expect about 11.2% in long-term total shareholder returns moving forward. These are slightly lower returns than those posted by the company during the past few years, as the company’s holdings are currently generating slightly less effective income. OXLC’s investors are also exposed to significant downside potential, if the company’s premium were ever to decrease to a more normal, sustainable level.

Even though I believe that OXLC is an outstanding company with an attractive return potential, the company is simply not a buy at these levels. In my opinion, investors should wait for the company’s effective yield to increase, and its premium to decrease, to more normal levels.

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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.

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2019-12-29