Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on April 4, 2022.

XAI Octagonal Variable Rate Alternative Income Term Trust (NYSE: XFLT) at been quite volatile lately. Since the last time we hedged the fund, the premium has increased a bit more. However, based on the 1-year z-score, we’re almost flat at -0.10, indicating that it’s not necessarily too expensive either.

We also saw some weakness in net asset value. This is of course the net asset value, what everything would be worth if the fund were liquidated today. XFLT is the only CLO fund that provides a daily net asset value to help value the fund. However, it is not a pure CLO and also holds a senior loan portfolio. This is essentially what the CLOs themselves are. These are mostly packaged loans then divided into different tranches. We covered this with a diagram in our previous article.

However, thanks to the daily reports on the net asset value, we can see that it has decreased. It would appear that geopolitical risks are hitting this fund harder. I suspect that other CLO funds that provide an estimated monthly net asset value will also be lower when reporting. Since Senior Loans are taken from companies rated below investment grade, they are more sensitive to weakness in the global economy. Not to mention that with the rise in rates, some investors fear that a recession is looming on the horizon. Recessions and publicly traded companies often don’t mix.

Due to the high volatility, an investor probably wouldn’t have to wait long to invest in XFLT at a better price. So for those patient investors, they might not have to jump on this fund at today’s price. On the other hand, going back to the discussion of rising interest rates, XFLT might be better positioned to take advantage of this event. Indeed, the underlying portfolio of senior loans and CLOs is mainly based on floating rates. This means that the fund could see higher income generation as rates rise.

The basics

• Z-score over 1 year: -0.10
• Premium: 10.43%
• Distribution yield: 10.34%
• Expense ratio: 3.86%
• Leverage: 39.82%
• Assets under management: $411.96 million
• Structure: Duration (early liquidation date December 31, 2029)

XFLT’s objective is to “seek an attractive total return with an emphasis on generating income through multiple stages of the credit cycle”.

They will do this through “a dynamically managed portfolio of floating rate credit instruments and other structured credit investments in the private markets. Under normal market conditions, the Trust will invest at least 80% of the assets managed in senior secured loans, CLO debt and CLO equity.”

Since our previous article, they have provided a prospectus supplement. This was due to a market offering they put in place to “offer and sell up to 18,300,000 shares of common stock.” This might worry some investors as it could lead to “dilution”. With the exception of CEFs, when funds can sell stocks at a premium, this is generally the best course of action.

Of course, your voting rights will be diluted – but the positives outweigh the negatives. If we’re being honest, most of us won’t own enough stock to really swing a vote anyway. In this case, we still benefit from selling stocks at a premium that is accretive to NAV and can result in higher earnings.

Another advantage is that the fund also grows, which could mean an increase in trading volume.

These ATM offers are in addition to secondary cash withdrawal offers in the past. An ATM offer works much the same but is done throughout the trading day. Secondary bids are announced and stocks usually drop instantly. So, in this way, the offers in the market are almost as disruptive.

The fund’s expense ratio compared to other CEFs seems absurd. However, this is the best deal you will get in the CLO space. They have no incentive fees, which keeps their expense ratio lower than other pure-play CLO funds. Excluding leverage fees, the fund’s expense ratio is 3.94%. Including the leverage effect, it amounts to 5.86%.

They are leveraged in the form of a preferred offering, 6.50% Term Preferred Shares Series 2026 (XFLT.PA). This is quite a high expense for leverage, but it will also not be affected by higher rates. Although they also have borrowings through a credit facility. This is subject to higher rates when interest rates rise, as it is based on one-month LIBOR plus 1.25%. This maturity date of the facility is March 22, 2023. So we still have about a year before that is renegotiated.

Performance – Premium Inch Superior

When we last hedged the fund, it stood at a premium of 6.88%. We now see a premium of 10.43%. As mentioned above, however, the fund has been quite volatile. This resulted in a fairly aggressive move in the fund’s premium.

Going back to the creation of the fund, we can see that a premium price is not too uncommon for stocks. He spent time negotiating discounts, but these were relatively brief. In 2020, we see the most notable discount as the fund plunged to over 30% discount. This type of deal did not last long, however. We can also see that since then the fund’s premium has remained elevated once it recovered from these lows. That’s why, even with a premium of 10% and above, there also doesn’t seem to be a time when one should sell immediately.

The fund can suffer massive declines in times of volatility. This is exactly what we can see with the fund’s discount/premium level. Below is a chart from inception to today on the performance of the fund. Based on price and net asset value alone, the fund fell. When we include distributions to look at total return numbers, we see a different story.

Most investors looking to invest in XFLT will focus more on the distribution and not the gains or losses anyway. Although at some point, too many net asset value losses could mean lower distributions for shareholders.

Distribution – Attractive monthly payment

Right now, despite the drop in net asset value since inception, XFLT is paying the same amount it hit during the pre-COVID crash. Throughout 2020 they did not reduce their distribution, but once they relaunched it returned to the previous level. For some investors, this excludes this fund. However, I believe that this fund had to be in a better position afterwards.

At that time, the distribution rate is 10.34%. On a NAV basis, this equates to 11.42%. Which is generally above my normal cautious zone of a 10% level. However, their coverage has also been quite strong.

Since they grew up with ATMs and secondary offerings and then the preferred stock they issued, it can be a little harder to track profits. That being said, at the end of their previous fiscal year, they had a net investment income coverage of almost 88%.

Ideally, for a more fixed income type of fund, we would like to see NII coverage greater than 100%.

They provided a quarterly update for the three months ending December 31, 2021. At that time, we see that NII coverage has dropped to around 68%. It can be useful for a quarterly fund update. However, a full year or even at least six months is a better indicator of coverage.

XFLT would probably be better suited to a tax-sheltered account for tax purposes. Most of the interest they generate from their underlying portfolio will be identified as ordinary income. That being said, 2021 has shown a significant portion of the distribution identified as return of capital. This could stem from the large amount of losses incurred in the previous year. Going forward, this shouldn’t be a regular occurrence.

XFLT portfolio

The fund has been very busy in its first two years. Since then, their turnover rate has been more moderate, relatively speaking. With their quarterly update, they note a rate of 8%. For the 2018 financial year, it reached 119%. This was then followed in 2019 by a turnover rate of 94%.

Looking back at the end of February 2022, we can see that senior secured senior loans make up the bulk of their portfolio. CLO equity is also a significant allocation, which is followed by CLO debt.

Overall, these major allocations have not seen a drastic change from the previous update at the end of October 2021. What is remarkable is that cash and cash equivalents previously represented around 10.25% of the fund. . This has now been drained to a more reduced level. This allocation was broad based as all other asset allocations increased slightly.

The fund reports that at the end of February 2022, they had a total of 448 positions. It’s only a touch of the 460 previously. Moreover, the average bond price as a percentage of par is 92.34%. That’s down 94.80%. This tells us that some of the declines in their portfolio’s NAV were simply the widening haircuts in the underlying loans.

They also put the effective maturity at 8.51 years. This is extended from the 7.48 years the fund had previously. Again, as mentioned above, the underlying is mostly floating rate loans and CLOs that hold senior loans. Therefore, the maturity of the portfolio is not going to be too detrimental in terms of the duration of the fund. Here is an excerpt from their latest annual report:

The Trust remains conservatively positioned in terms of duration; the vast majority of the Trust’s portfolio is invested in floating rate or adjustable rate securities based on changes in LIBOR…

Conclusion

XFLT is a bit high due to its longer term history. However, the fund is not yet screaming to sell, at least in my opinion. The most recent trading range has put XFLT at a fairly substantial premium fairly consistently. Investors seem to appreciate the higher income the fund can generate from their underlying portfolio of CLOs and senior loans. However, coverage is not quite 100%, so will need to continue monitoring as new data becomes available.