For high-yield-oriented investors, I believe this is a solid portfolio with an annual dividend yield of over 11% and the potential for capital gains. Currently, the five business development companies (BDCs) that I consider to be the best high-yield mix are Prospect Capital (PSEC), TICC Capital (TICC), Medley Capital (MCC), Fifth Street Finance (FSC), and Solar Capital (SLRC). In my last article, "A BDC Investment Philosophy And 4 Portfolios," I discussed what BDCs are and why I see them as good investments. I also talked about four different approaches to investing in BDCs, taking into account various investor needs. Out of the 25 BDCs that I follow, I will pick five for each portfolio type (with the exception of the general portfolio) along with recommended weightings. The four types of portfolios that I will cover are:
- General Optimal
- Risk Averse
- High Yield
- Value and Growth
The High-Yield Portfolio
This portfolio is for investors that are willing to take on a little more risk with less capital appreciation, but higher dividend yields. The following allocations for a high-yield BDC portfolio are used for the remainder of the information in this article, and all metrics are weighted accordingly. Investors who want a slightly less risky portfolio with a higher-than-average yield can adjust the weightings higher for FSC and MCC, and lower for PSEC and TICC, but reducing the overall dividend yield.
Click to enlarge images.
These are the five general criteria I use to evaluate BDCs followed by my most recent BDC ranking table. I have included the High-Yield Portfolio as a group in the chart indicating how a portfolio with my recommended weighting would compare to the other BDCs. The profit category is the only one that is lower than the average, mostly because of the higher payouts of these BDCs -- which is what gives them a higher yield.
- Profitability (EPS to cover dividends, NAV and EPS growth)
- Risk (rate sensitivity, diversification, portfolio quality, volatility)
- Payout (sustainable, consistent, growing)
- Analyst Opinions
- Valuation (NAV, P/E, PEG)
When evaluating high-yield investments, it is important to understand if the dividends are sustainable, ideally through net investment income (NII) with special dividends covered by realized capital gains. All five of these BDCs have been actively raising capital through debt and equity offerings, making it difficult to normalize EPS to get a run rate of expected NII per share. In many cases, there are timing differences between the capital raised from issuing shares and the amount of income received from deploying that capital. The result is quarter-to-quarter variances and a potential temporary lack of coverage of dividends from NII, especially with PSEC and TICC that invest in Collateralized Loan Obligations (CLO) that can have up to a two-quarter lag of revenue recognition as discussed in "TICC Capital: High Dividends And Low Price."
Ultimately, these companies should be able to sufficiently cover dividends with NII. PSEC recently announced the following:
We intend to continue earning net investment income that covers and provides the opportunity to increase our dividends. Our objective is to increase net investment income and dividends over time by expanding prudent leverage, increasing our mix of higher yielding originations, and from time to time making accretive acquisitions.
It is also important to watch for NAV stability to indicate if the value per share is stable after paying its high dividends. Historically, all five of these BDCs have had NAV per share growth or stability.
Along with high-yield BDCs comes higher risk. Some investors believe that perhaps they are just underpriced, and that might be true some of the time. But, in general, the market has a way of pricing things efficiently -- especially in the case of BDCs with large amounts of institutional investors who own over $12 billion, or almost half of the industry, and often have teams of analysts as well as access to corporate and market data that most retail investors do not. In a recent series of articles, I covered the risk profiles of 25 BDCs. The following is a chart showing the most recent relative risk ranking with a weighted average rank of 6.7 for the high-yield portfolio (a rank of 10 implies the least amount of risk). Again, investors looking for less risk should adjust allocations accordingly.
One of the benefits of investing in a portfolio of BDCs is increased industry diversification. The charts below represent the combined exposure by industry for the portfolio. Currently, there are four recommended sectors for overweight: Financials, Consumer Discretionary, Healthcare, and Industrials (as discussed in "BDC Risk Profiles: Part 5 - Industry Diversification"). This portfolio is well positioned given that those sectors make up 56% of total investments. In my opinion, CLOs can be riskier than traditional investments because many are less transparent than direct investments in portfolio companies, have a lower repayment priority, are thinly traded (making them less liquid), are difficult to value, and are more volatile. However, using these allocation, CLOs only make up 11% of the overall investments and provide much of the higher yields from PSEC and TICC.
Recently, the Fed's comments pushed up the yield on the 10-year Treasury note to the highest level in almost two years. In my article "BDC Risk Profiles: Part 6 - Interest Rate Sensitivity" I focused on the interest rate sensitivity for BDCs considering fixed vs. variable rate investments compared to the amounts borrowed to fund those investments. The high-yield portfolio has a weighted average 73% of debt investments with variable rates and is higher than the average BDC with 66%. However, it does have a higher debt-to-equity ratio of 0.63 compared to the average of 0.57, with average interest coverage from NII of 4.5 as shown in the following chart:
I believe that most BDCs will benefit from rising interest rates given the high amounts variable rate investments and fixed-rate borrowings. In a recent statement from PSEC, the CFO stated: "Prospect has locked in a ladder of fixed rate liabilities extending 30 years into the future, while most of Prospect's loans float with LIBOR, providing upside to shareholders as interest rates rise."
The weighted average amount of senior debt for this portfolio is 69% of the fair value of total investments, 19% subordinated debt and 12% equity type of investments, giving it an better-than-average investment grade of 4.2. I use the "Quarterly Interest and Dividends Percentage" metric to indicate portfolio yields for each BDC. This measures the amount of dividend and interest income (excluding income resulting from amortization of fees, discounts, or other income) in the most recent quarter annualized and divided by the average fair value of the income-producing investments during that quarter. Typically, higher-yield investments indicate higher amounts of risk. This portfolio has a higher than average yield, which is why it can afford to pay a higher than average amount of dividends as shown in the table below. The general direction of these yields are headed down, implying that these BDCs are not moving toward riskier investments and potentially investing in more senior safer types.
In general, this portfolio should have better-than-average volatility ratios and higher-than-average institutional and insider ownership levels.
Obviously, this portfolio has a higher than average dividend yield at 11.1% compare to the current average of 9.1%. At this point I would not expect to see much growth in dividends paid, with the exception of MCC and maybe TICC.
Analysts have relatively higher opinions for most of these BDCs with the exception of PSEC and TICC with average expectations. Target prices for the group are around 10% higher than current levels, indicating potential upside in stock prices.
Ideally, each BDC would be priced along a valuation curve with investors paying a premium for favorable risk-to-reward ratios. Below is a table using my relative risk ranking to categorize each BDC into valuation levels and appropriate multiples of NAV, LTM EPS and 2013 EPS, but does not include the NAV multiple for ACAS due to it being an outlier in many respects and uses a normalized LTM EPS for PSEC (adjusted for the Gas Solutions sale):
As you can see, PSEC, TICC, MCC are priced lower than the average BDC contributing to their currently higher yields. And given the lower risk levels of FSC, it is priced relatively low as well. My price target for these four BDCs are almost 20% higher than their current prices and around 12% higher for SLRC.
In a healthy market, riskier BDCs such as TICC and PSEC usually payoff especially with higher yielding investments like CLOs. When TICC's CFO was asked about the recent purchase of a distressed investment that added to the non-accruals for the quarter, the CFO replied: "prior to making our first CLO investment, we haven't made any CLO investments and then when we did make one, then we made a few more and it's actually become an incredibly profitable segment of our business. I'm not saying that, that's going to happen here. I'm just saying that we are opportunistic debt investors and this was a good opportunity."
For high-yield-oriented investors, I believe this is a solid portfolio with a dividend yield of over 11% and the potential for capital gains. I would expect a short-term sell-off if interest rates spike and other yield investors move on to other types of investments. This could be a buying opportunity for long-term investors who continue to watch the underlying fundamentals of these investments. I will provide updates for this portfolio as needed, including shortly after each quarterly earnings release, with updated allocations or overall changes. I would not recommend enrolling in a dividend reinvestment plan unless it is with the individual company at discounted prices. Instead, I would use the proceeds to fine tune allocations each quarter.
Investors should only use this information as a starting point for due diligence. See the following for more information:
- List of 25 BDCs that I follow and the associated focus articles
- Weekly newsletter with price targets
- "A BDC Investment Philosophy And 4 Portfolios" for general BDC information (linked to above)
- BDC Risk Profiles