ECC's 18 Percent Yield Hides Unrated CLO Equity Tranches Most Income Investors Have Never Heard Of

Eagle Point Credit Company is a closed-end fund that generates high distribution yield by investing primarily in CLO equity tranches. A CLO pools leveraged corporate loans and divides cash flows into seniority-based tranches, where AAA-rated tranches are paid first and equity tranches receive remaining interest after all rated tranches. Equity tranches also absorb the first dollar of losses when borrowers default, which supports high yields in normal credit conditions. When leveraged loan defaults rise, payments to higher-rated tranches continue, but losses reduce cash flow to the equity tranche, shrinking distributions and lowering net asset value. During March 2020, the fund’s value fell sharply as default expectations repriced, and selling during the drawdown locked in losses.

"A CLO bundles hundreds of leveraged corporate loans and slices the cash flows into tranches stacked by seniority: AAA, AA, A, BBB, BB, and equity. The AAA holders get paid first and absorb losses last. The equity tranche sits at the bottom. It collects whatever interest is left after every rated tranche is paid, and it eats the first dollar of loan losses when borrowers default."

"That position is why CLO equity yields 15% to 20% in normal credit conditions. ECC concentrates almost entirely in those equity slices, which is also why it can advertise a payout the rest of the income market cannot match. The yield is compensation for sitting in the first-loss seat of a leveraged loan pool."

"When leveraged loan defaults rise, the rated tranches above ECC's holdings still get paid in full. The shortfall lands on the equity tranche. Distributions to ECC shrink, the underlying CLO equity marks down sharply, and ECC's net asset value follows. In March 2020, ECC lost roughly 50% of its value in weeks as the market repriced default expectations."

"It eventually recovered, but anyone who needed to sell during the drawdown realized the loss permanently. The stress is already visible without a recession. ECC is down 21% year to date and 32% over the past year, with shares around $4."

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