Eagle Point Credit Company (ECC) has been celebrating milestones. They've returned 100% of their IPO price to shareholders in the form of cash distributions, a feat few companies can boast. Their recent earnings calls were filled with optimism, highlighting a strong 2023, robust cash flows, and promising investment opportunities.

But beneath the surface of this seemingly impeccable performance, a hidden risk lurks – one that seems to have escaped the notice of analysts. ECC's aggressive strategy of refinancing and resetting CLOs, while currently boosting their returns, could backfire spectacularly if loan prices experience even a modest decline.

Here's why. ECC's portfolio is heavily weighted towards CLO equity, a high-risk, high-reward investment strategy. To maximize returns, they've been actively refinancing and resetting their existing CLOs, taking advantage of the current low interest rate environment. This has allowed them to lower the cost of debt for their CLOs, increasing the spread between the interest they earn on the underlying loans and the interest they pay on the CLO debt.

This strategy, however, hinges on one crucial factor: **the continued high price of loans.** ECC acknowledged that the price of loans is currently "too darn high," with many trading at or above par. This means that the underlying loans in their CLOs, many of which were purchased at a discount, are currently sitting on significant unrealized gains.

The problem is, these gains are a double-edged sword. As long as loan prices remain high, ECC benefits from a lower effective yield on their CLO equity, leading to a lower taxable income and potentially allowing them to treat a larger portion of their distributions as a return of capital for tax purposes. This explains the discrepancy between their GAAP net income, which includes a reserve for losses, and their recurring cash flows, which are currently exceeding expectations.

What if Loan Prices Decline?

Even a modest drop could trigger a cascade of negative consequences for ECC.

Firstly, those unrealized gains would evaporate, leading to a spike in ECC's effective yield and taxable income. This could force them to distribute a larger portion of their earnings as taxable dividends, potentially reducing the attractiveness of their stock to investors seeking tax-advantaged returns. Secondly, the refinancing and resetting strategy, which relies on the ability to issue new CLO debt at lower spreads, becomes less effective. If loan prices decline, CLO debt spreads are likely to widen, eroding the potential benefits of refinancing and resetting. Thirdly, ECC's portfolio, with its above-average weighted average remaining reinvestment period (WARRP), becomes more vulnerable. A longer WARRP is generally desirable, as it provides more time to reinvest principal payments at potentially higher spreads. However, in a declining loan price environment, a longer WARRP can also mean locking in losses for a more extended period.

Consider this: ECC's weighted average AAA spread is currently 146 basis points, right at the current market rate. However, a significant portion of their CLOs have AAA spreads well above this level, as seen on page 26 of their investor deck. They're currently able to refinance and reset these CLOs at lower spreads, but this opportunity will quickly disappear if loan prices decline and AAA spreads widen.

The question isn't if loan prices will decline, but when. While the exact timing is unpredictable, it's crucial to recognize that the current high prices are unsustainable. Eventually, gravity will take hold, and ECC's aggressive refinancing and resetting strategy could leave them exposed.

The Numbers Tell a Story

ECC's GAAP net income and recurring cash flow per share for the past two quarters indicate that their current cash flow is heavily reliant on unrealized gains. If these gains disappear, their cash flow could decline significantly.

Recurring Cash Flow Trend

While ECC's April 2024 recurring cash flow exceeded the previous two quarters, it's essential to consider this in light of the potential impact of declining loan prices. The sustainability of these cash flows is a critical factor for investors to evaluate.

This isn't to say that ECC is doomed. They have a strong track record of managing their portfolio, and their focus on longer WARRP CLOs could provide some buffer against future volatility. But investors should be aware of the potential risks associated with their current strategy.

The "high class problem" of excess cash flow could quickly become a painful headache. The time bomb is ticking, and it's up to investors to decide whether the potential rewards outweigh the hidden risks.

"Fun Fact: ECC has paid out a total of $20.15 per share in distributions since its IPO in 2014, marking a significant return for early investors. However, the potential impact of declining loan prices on future cash flow underscores the importance of understanding the underlying risks associated with ECC's investment strategy."