XAI Octagon's Q2 2025: Contradictions Emerge on CLO Spreads, Loan Market Stability, and XFLT's Distribution Strategy

The above is the analysis of the conflicting points in this earnings call

Guidance:

- Expect potential Fed rate cut in September; lower base rates would reduce income on floating assets but also lower leverage costs and improve borrower fundamentals.- Spread compression remains a headwind; repricings are active. Management will continue refinancing/resetting CLO liabilities to mitigate, acknowledging the lag vs loan spread moves.- Markets more constructive in Q3; adding CLO equity at higher yields with longer reinvestment periods and selectively adding BB tranches.- Target leverage around ~40% (current ~37%); leverage managed dynamically with diversified sources; credit facility cost should decline if rates fall.- Portfolio positioned defensively in pressured sectors (chemicals, building products) while pursuing selective opportunities.- Distributions realigned to earnings after 9.09% cut; policy monitored.

Business Commentary:

Fund Performance and Distribution Changes:* - XAI Octagon Floating Rate & Alternative Income Trust (NYSE:XFLT) reported a 9.09% reduction in its monthly distribution, from $0.077 to $0.070, payable July 1. - This decrease was necessitated by the carryover pressure from Q1 tariff-related issues, which also affected all XFLT's competitors.

• Market Outlook and Morningstar Ratings:
• XFLT received an overall Morningstar 5-star rating for both the 3-year and 5-year periods, categorized in the broader loan category for listed closed-end funds.

• The fund outperformed its peers, reflecting favorable performance against its benchmark and within its peer group.

• CLO Equity and Debt Market Pressures:

• CLO equity current yields are at 23%, with mark prices at $51.98, indicating pressure due to declining prices.

• CLO debt current yields are 10.51%, marked near par at $99.58, while loan market yields are at 7.86%, marked at $97.5.

• Leverage and Financial Strategy:

• XFLT's leverage ratio stands at about 37.79%, slightly below its typical target of 40%, reflecting volatility in the market.
• The fund employs a mix of leverage sources, including a floating rate credit facility and preferreds, managed dynamically to align with market conditions.
  

  Sentiment Analysis:

  • Management cited NAV pressure and a 9.09% distribution cut due to spread compression and tariff-related volatility, and noted CLO equity valuation declines. Offsetting this, loans returned ~2.6% in Q2, CLO BBs returned >3.6%, Q3 conditions are "more constructive," and borrowers show mid- to high-single-digit EBITDA growth with potential rate cuts supportive. They are actively refinancing/resetting CLO liabilities and targeting ~40% leverage while adding higher-yielding CLO equity.

  Q&A:

  • Question from Kevin Davis (XA Investments): How did leveraged loans perform in Q2 amid April volatility?
  • Response: Loans returned ~2.6% in Q2 with CCCs outperforming, aided by M&A takeouts and HY market access for weaker borrowers.
  • Question from Kevin Davis (XA Investments): What is the macro/borrower outlook (jobs, consumer, tariffs)?
  • Response: U.S. conditions remain supportive; labor steady, borrowers seeing mid- to high-single-digit EBITDA growth; tariffs’ full impact pending; lower rates would help.
  • Question from Kevin Davis (XA Investments): How are loan/CLO spreads trending and what’s the impact on XFLT earnings?
  • Response: Spread compression (~50 bps over 18 months) resumed; July saw record repricings (>10% of market, ~50 bps savings), pressuring loan income and CLO equity; liability refis help but lag.
  • Question from Kevin Davis (XA Investments): How healthy are borrowers given rising CCC downgrades?
  • Response: About $12B of new CCC downgrades YTD, but CLOs reduced CCC holdings via sales/refis; OC cushions robust; leverage/coverage stable and should improve if rates fall.
  • Question from Kevin Davis (XA Investments): How did CLOs perform and how are you navigating?
  • Response: CLO BBs +>3.6% in Q2; equity under pressure from spread compression and risk concerns; added equity at higher yields/longer reinvestment and BBs; refis/resets remain key.
  • Question from Kevin Davis (XA Investments): What would a prospective Fed rate cut mean for XFLT?
  • Response: Lower SOFR reduces income on floating assets but also lowers credit facility costs; fundamentally positive for levered credit and CLO equity over time.
  • Question from Kevin Davis (XA Investments): How does XFLT’s performance and mix compare to peers?
  • Response: With ~46% loans, ~38% CLO equity, ~12.3% CLO debt, the fund outperforms peers/benchmark over 3- and 5-year periods; 1-year is in line.
  • Question from Kevin Davis (XA Investments): How do you view and deploy leverage?
  • Response: Leverage was 37.79% at 6/30, below the ~40% target by design; diversified via floating-rate credit facility and preferreds; costs should decline if rates fall.
  • Question from Kevin Davis (XA Investments): Would you repurchase shares when trading at a meaningful discount?
  • Response: Buybacks are an option but provide temporary benefits and can raise expense ratios; focus is on driving natural demand through outreach and education.
  • Question from Kevin Davis (XA Investments): How are distributions managed given return of capital?
  • Response: Monthly distribution cut 9.09% (from $0.077 to $0.070) to align with earnings; preference for stability but will adjust to avoid prolonged ROC.
  • Question from Kevin Davis (XA Investments): What advantages does the closed-end structure have vs CLO ETFs?
  • Response: CEFs better house episodically illiquid CLO assets, avoiding forced selling; can use leverage; daily NAV and third-party valuations; ETFs face flow-driven liquidity and wider spreads in stress.
  • Question from Kevin Davis (XA Investments): Any sector highlights/lowlights within the loan book?
  • Response: Chemicals and building products are pressured; positioning emphasizes specialty chemicals and nondiscretionary end markets/distributors to balance defense and opportunity.