Eagle Point Income: A Less Risky CLO Alternative To ECC

seekingalpha04-23

Eagle Point Income offers a high monthly distribution with a yield of 15.4%.EIC has outperformed the S&P 500 in terms of total return, thanks to its high cash flow and distributions.The price of EIC ...

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This is less risky due to the position of repayment on the capital structure.Higher interest rates have benefitted EIC as the company has been able to obtain higher NII levels while actively deploying capital towards new investments.biffspandex/E+ via Getty Images Overview High yielding monthly income is something that has already been appealing to me. As an investor that values income, I'm always on the hunt for opportunities to increase my annual passive income. Eagle Point Income Co Inc (NYSE:EIC) offers a monthly distribution with a high yield of 15.4%. EIC operates as a closed-end fund with a primary focus on CLO debt. While entities like this can certainly carry a certain level of risk, it's important to understand what these funds are made up of. I aim to provide an easy-to-understand analysis of EIC and why it may deserve a spot in your portfolio. Data by YCharts We can see that over the last year, EIC has slightly outperformed the total return of the S&P 500 (SPY). While a direct comparison to the SPY doesn't really mean much in this context, it does help paint a clear picture of the power of high distributions over time. A comparison to the SPY doesn't really align with the main purpose of EIC, which is to produce income. While a total return profile that closely aligns in the short term is great, investors in a closed-end fund aren't typically after a higher total return. Instead, they are usually looking for consistent income generation that can be used to fund their daily lives. Despite the price of EIC moving up only 6.7% for the year, EIC's total return is superior because they were able to generate high levels of cash flow in this higher interest rate environment to support the distributions. Despite the fund's history only starting in 2019, the performance has been strong so far. My Buy thesis is supported by the utility potential of a strong distribution that is likely to remain well-covered in a high interest rate environment. The high distribution is essential for those at the retirement phase of their investing journey; where they need the income to fund their daily lives. Conversely, the investor with plenty of time on their side can also benefit from a CEF like EIC. Collecting a monthly distribution makes holding through volatile market periods a lot easier to achieve on a psychological level. The monthly distributions can be reinvested into other areas of the portfolio and can serve as a tool to build up a cash cushion within your portfolio if you choose not to reinvest. Strategy EIC's main objective is to generate high current income, with a second goal of generating capital appreciation when possible. They achieve this by focusing on mostly CLO debt. Collateralized Loan Obligations are pools of debt into single securities. These CLOs are often sourced from corporations that have been classified as below investment grade, with a rating of BB- and below. All of these BB- rated CLO securities are floating rate based and have benefited from the higher interest rate environment. EIC Q4 Presentation EIC's effective yield on their portfolio is 13.29%. Within the portfolio, there are over 1,400 underlying loan obligors, with the largest individual obligor accounting for 0.73% of the total portfolio. With so many individual obligors within, the average individual loan obligor exposure sits at only 0.07%. For reference, the top ten obligors only account for 5.57% of the total portfolio. This exposure allocation demonstrates how well diversified EIC attempts to be, and this helps mitigate any sort of concentration risk. Speaking of diversity, EIC is also diverse across many different industries. The top ten industries account for approximately 48.8% of the total portfolio. The top sector exposure is within technology software and services, accounting for 11.1%. Tech companies are more likely to thrive in an environment with lower interest rates, as this means they can increase borrowing and fuel more growth within their business. Therefore, I think that we have the potential to see some nice upside movement when market conditions improve and rates are cut. Additionally, the remaining larger sector exposures are media, accounting for 6.5% and healthcare providers and services making up 5.6% of the total portfolio. EIC Q4 Presentation Lastly, management has done a great job at distributing the spread across portfolio maturity. Less than 8% of the underlying portfolio matures before 2026. While the number of obligors to mature in 2028 is considerable, we have plenty of time down the road to get those loans sorted out. Market conditions can be entirely different by then, so I see no reason to worry here. The main standout item is that the maturity schedules for the next two-year period are solid. Risk Profile & Comparison At the beginning of April, I published an article on EIC's sister fund, Eagle Point Credit Co LLC (ECC) titled 'Eagle Point Credit: Earn A High Yield From CLOs'. The fund is similar in many regards, but EIC remains the fund that is generally considered less risky. This is due to the way ECC focuses more on the CLO equity tranche, whereas EIC holds primarily CLO debt, which is higher on the capital structure. EIC Q4 Presentation EIC's asset breakdown consists of CLOs making up 73% of the total portfolio. The remaining 27% consists of CLO equity. Also, nearly 70% of the total portfolio consists of credit quality rated B, 20% is rated BB-, and 7% is rated CCC. In comparison, ECC's portfolio comprises approximately 69% CLO equity. ECC's structure chooses to focus on CLO equity, which has a higher risk/reward aspect to it. If NII (net investment income) grows and portfolio companies can't maintain debt obligations, their reward for ECC can be greater. For example, ECC has been rewarded shareholders with supplemental distributions for nearly two years now. In comparison, EIC has not paid out any supplemental dividends since 2021. Data by YCharts They achieved this as NII grew due to a higher interest rate environment. However, there's a possibility where the prolonged period of interest rates may cause pressure on portfolio companies and the ability to maintain the interest payments on debt causes defaults. This scenario would be more negative for ECC than EIC. However, we can see that EIC still has a superior total return since its inception in 2019. Conversely, EIC holds more of the debt tranche of CLOs. In terms of capital structure, the senior secured debt is safer because it gets priority for repayment if liquidations were to occur. The equity tranche is last in the capital structure and the investors carry more risk there. So how risky are these funds exactly? Well, looking at the historical default rate from 1996 to 2022, the numbers tell us that defaults are actually quite low. According to page 8 of their latest presentation, a total of 25 out of 2,323 tranches, equivalent to 1.1% have defaulted between this time period. In fact, there is also external data cited from S&P Global that reinforces the fact that CLO defaults are historically low. This is certainly a calculated level of risk that I am comfortable with. Don't forget that this time frame also includes major economic events like the dot com bubble, the great financial crisis in 2008 & 2009, and even the market drop caused by the pandemic in 2020. While BB- rated debt can be risky, the management has done a great job at selection here. EIC Q4 Presentation While the dividend yields are quite similar for both ECC and EIC, EIC carries much less of a risk level due to the structure. ECC's dividend yield is currently 16.8% and there have been a ton of supplemental dividends issued. EIC's dividend yield is only about 15.4%. Therefore, ECC has a much higher distribution policy currently, but the trade-off is the potential to take on more risk should market sentiment turn bad in an environment of prolonged high interest rates. Financials - Dividend Coverage At the end of February, EIC reported their Q4 earnings and closed off the 2023 fiscal year data. I think the report was great as it highlighted the capabilities of generating a high level of cash flow and the NAV grew for the year. The net asset value of the fund grew to $14.39 per share, up 2.2% from the prior quarter. Management also provided an update for Q1 of 2024 by indicating that NAV has continued to grow to $14.94 per share as of February 15th. In addition, the GAAP net income came in at a weighted average of $0.74 per share. This high level of cash flow meant that the company was able to also deploy an additional $26M in net capital towards new CLO debt and equity investments. Capital allocated towards more growth sources is always a great indicator of strong growth. These new CLO investments can very well continue to contribute to growth in NII to support a growing distribution. For Q1 of 2024, they've also managed to deploy an additional $8.9M into CLO debt, equity, and other investments. This consistency to fuel growth is really encouraging to see and instills lots of confidence in me. A growing NAV is also a sweet bonus, and this translates to the probability of seeing more price appreciation over time while simultaneously avoiding NAV erosion since distributions are fully covered. EIC Q4 Presentation The distribution was increased by 11.1% to $0.20 per share in January. This brings the current dividend yield to 15.4%. The distribution was slightly cut in April 2020, which is understandable given the shock effect that COVID-19 and the pandemic had on the market. Since then, the distribution has steadily increased every year, and we have now surpassed the pre-covid distribution amount of $0.1326 per share in 2019. The higher distribution has been well-supported by the growth in NII. According to the latest CPI report, inflationary data has come in higher than anticipated. As a result, the Fed seems to be dragging their feet and awaiting more economic data to roll in before considering rate cuts. The new consensus seems to be that rate cuts aren't very likely until the end of the year and will possibly happen in September. I tend to lean towards the viewpoint that it's still possible that we see a rate cut at the end of the year, but I also wouldn't be surprised if it ultimately gets pushed to 2025. The Fed propped the market up to new highs in 2021 when rate cuts were aggressively cut prior, and I think they don't want to make that same mistake. In addition, I think with the recent rise of market indexes, the Fed may remain cautious about cutting rates. Rate cuts would have the potential to fuel additional inflows of capital and excessive risk-taking. We already see the S&P up over 21% and the Invesco QQQ Trust ETF (QQQ) up over 32% for a 1-year time frame. I believe that premature rate cuts may cause valuations to inflate further, potentially fueling asset bubbles and instability. Data by YCharts If higher interest rates remain the case, I think it's fair to assume we can see continued strength in NII. This translates to a healthy cushion of dividend coverage. NII for Q4 was reported at $0.74 per share. This covered the distribution of the prior three months with a very healthy margin of safety. While ECC has a higher dividend yield of 16.8%, EIC's high yield of 15.4% offers a more assuring layer of security in comparison due to the strong NII and capital debt structure. Valuation In terms of valuation, we can determine where the price stands by taking a look at the historical price-to-NAV (net asset value) relationship. Closed-end funds are structured a bit differently because their price can trade at a difference compared to what the underlying assets are actually worth. The NAV is the accounting value of everything within EIC. The price is controlled by the supply and demand of shares. For the case of EIC, NAV is where the fair value may actually lie since the price range has rarely ever crossed above a 10% discount or premium throughout its history. This means that it's typically more ideal to obtain shares in a quality CEF when the price trades at a discount to its NAV. Conversely, there are many funds that have strong performance histories and expert fund managers. As a result, we can see instances where shares consistently trade at a premium to NAV because the demand is high. Over the last 3-year period, the price has traded at an average premium of 4.08%. The price currently trades at a slight premium to NAV of 3%. While this isn't in the preferred discount territory, it still sits below the average premium which could indicate a good opportunity for entry. We did see very brief instances where the price touched the discount territory in 2022 but the chances to enter at a discount have been slim. CEF Data We've seen the price consistently trade between the $13 - $16 per share range over the last two years. While an entry closer to the $13 per share level would be more ideal in terms of a price entry, I think initiating a position here is also suitable. While interest rate cuts may harm net investment income, it may also have a positive effect on prices. Additionally, throughout 2023 management was able to raise capital through their ATM (at the market program) by issuing over 1 million shares at a premium to NAV. The way this works is beneficial for EIC because they can choose to issue more shares when demand for the fund is high and trading above NAV like it is currently. This is a way to amplify NAV growth since EIC can issue more shares at times when the NAV is higher. When this took place during the quarter, EIC experienced slight NAV growth of $0.03 per share during the quarter. In comparison, ECC's price currently trades at a premium to NAV of 8.73%. ECC has frequently traded at a premium to NAV in comparison, but it has also had many more instances of the price dipping into discount territory. This more frequent trading in the discount price territory is a reflection of the fund's lesser quality of holdings. When you compare both charts, we can see that EIC's price swings are a lot less volatile since their portfolio contains higher quality investments. This more stable price range is what makes EIC stand out to me. ECC's Price To NAV History (CEF Data) A lowered interest rate means that EIC will likely receive less interest income on the debt it invests in. However, taking a look at the chart below we can see the inverse relation that EIC's price has traded with so far. When the effective federal funds rate was cut near zero, the price of EIC started to soar throughout all of 2021. However, when rates started to rapidly increase, we saw the price of EIC tumble down from the $18 per share mark. While the estimated rate cuts aren't expected to be extreme at the end of the year, there is a possibility that it will impact the price. Data by YCharts Takeaway  Eagle Point Income Co Inc (EIC) offers a less risky alternative to the sister fund Eagle Point Credit Co LLC (ECC). While both funds still carry inherent risks, EIC's structure of CLO debt makes their portfolio a higher priority on the capital structure in terms of repayment due to defaults. While EIC offers an attractive high yield over 15%, the distribution may vary in a changing interest rate environment. However, I anticipate the interest rate to remain elevated which should benefit EIC by seeing increased levels of interest income. In terms of valuation, EIC sits at an attractive entry price and could see more price appreciation when rates are cut. 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