This article is a follow up to "A BDC Investment Philosophy And 4 Portfolios," where I discussed what BDCs are and why I see them as good investments as well as four different approaches to investing in BDCs, including the 'Risk Averse' portfolio. The BDC sector can be volatile but this portfolio attempts to find lower risk investments with an annual dividend yield of almost 8% and the potential for special dividends and capital gains. Currently, the five investments for a lower risk BDC mix are Main Street Capital (MAIN), Ares Capital (ARCC), PennantPark Floating Rate Capital (PFLT), Prospect Capital Senior Notes (PRY) and TCP Capital (TCPC). 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:
The Risk Averse Portfolio
This portfolio is for investors who do not want to worry or 'babysit' their investments and are not using them as a major source of income. Many of the lower risk BDCs have higher multiples contributing to lower average yields, but during market corrections, they tend to outperform the others with less volatility and still pay a healthy dividend with long term capital appreciation. The following allocations for a lower risk BDC portfolio are used for the remainder of the information in this article, and all metrics are weighted accordingly.
Other BDCs Considered
While trying to come up with a lower risk BDC mix there were other companies that I considered for this portfolio. Golub Capital BDC (GBDC) is one of the lower risk candidates but I did not include it for a few reasons, but it was mostly due to it being overpriced and having higher amounts of leverage. MAIN is also overpriced but has a history of higher net asset value ("NAV') per share growth to support higher multiples. Another consideration was Solar Senior Capital (SUNS) but currently it is unable to cover dividends and is not to projected to for a while.
These are the five general criteria I use to evaluate BDCs followed by my most recent BDC ranking table. I have included both the Risk Averse and High-Yield portfolios in the chart indicating how a portfolio with my recommended weightings would compare to the other BDCs.
- 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)
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As you can see the risk averse portfolio has a higher ranking for profit, risk, and analysts, but lower for payout and valuation compared to the high-yield portfolio.
Prospect Capital Senior Notes Due 2022
On May 1, 2012, Prospect Capital (PSEC) issued $100 million in senior unsecured notes due 2022 with an annual interest rate of 6.95% paid quarterly. These notes trade under the symbol "PRY" with a current yield of 6.7% and are an unsecured obligation with a Kroll rating of BBB+ and an earliest call date of May 15, 2015.
When evaluating BDCs, it is important to understand if the dividends are sustainable, ideally through net investment income ("NII") and special dividends covered by spillover taxable income or realized capital gains. All of these BDCs have recently been 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 table below shows the current dividends and projected EPS for the calendar Q4 2013 for each BDC:
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It is also important to watch for NAV stability to indicate if the value per share is stable after paying its dividends. Historically, all of these BDCs have had NAV per share growth or stability.
In a recent series of articles, I took an in-depth look at the relative risk levels of each BDC. Specifically, I looked at portfolio credit quality, investment asset classes, diversification, non-accrual rates, portfolio yield, fixed/variable rate loans, leverage, interest rate sensitivity, volatility ratios, market capitalization, insider ownership and trends, institutional ownership and trends, and management/operational history for each BDC. The following chart shows the most recent relative risk ranking with a weighted average rank of 8.3 for the risk averse portfolio (a rank of 10 implies the least amount of risk).
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 risk averse portfolio has a weighted average 75% of debt investments with variable rates, higher than the average BDC with 61%, and an average debt-to-equity ratio of 0.52. However MAIN recently paid down much of its debt with the proceeds from its latest offering. I believe that most BDCs will benefit from rising interest rates given the high amounts variable rate investments and fixed-rate borrowings.
The BDCs in this portfolio have much higher amounts of senior debt investments with lower yields implying a lower amount of credit risk but lower yields to investors as well. MAIN and ARCC have longer operating histories and larger market caps compared to TCPC and PFLT, but I believe this provides for a good balance.
This portfolio has a lower than average dividend yield at 7.6% compare to the current average of 9.2% but this does not take into account the 'total return'. Recently I discussed the total return for MAIN in "Main Street Capital: More Than Just Dividends?" including its regular dividend growth, NAV per share growth, and special dividends, to come up with total expected return that is higher than most BDCs.
All of the BDCs in this portfolio have a history of growing dividends (especially MAIN and PFLT) and MAIN, TCPC, and ARCC have recently paid out special dividends that should be considered when comparing overall yields.
On the most recent earnings call, the CEO of MAIN explained: " During the course of our last conference call, I referenced our spillover taxable income of over $40 million at March 31. As of June 30, we estimate that our spillover taxable income is $46 million. In order to reduce this amount, stay in compliance with a regulated investment company tax rules and reduce the 4% federal excise tax payable on the spillover amount that carries over into 2014, we expect to ask our board later this year to declare our next semiannual supplemental dividend of at least $0.20 a share payable on or around year end. We continue to expect that we will pay semiannual supplemental dividends going forward for the next few years in addition to our regular monthly dividends."
Analysts have much higher opinions for all of these BDCs and target prices for the group are around 7% 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):
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All of these BDCs, with the exception of MAIN, are priced near the average BDC and my price targets for ARCC and PFLT are approximately 5% to 10% higher and for TCPC is almost 20% higher. MAIN has high multiples but as discussed earlier I believe it is priced for total return due to the highest NAV per share growth among dividend paying BDCs.
This is a solid portfolio for investors that want a low maintenance BDC portfolio with lower yields compared to the other BDC portfolios but higher than the average equity investment. The tax treatment of the distributions for this portfolio is more favorable than other BDCs but changes every year. In my weekly newsletter I track the performance of the 25 BDCs that I follow and currently they are on an upswing as seen in the chart below;
Many of the 'safer' BDCs are overpriced due to yield seeking investors that are concerned about capital preservation. As interest rates spike, many of these investors will sell baskets of high yielding stocks regardless of the underlying fundamentals. This should be seen as an opportunity to buy for the long term. I believe this was the case for PFLT which has fallen 10% over the last two months and is now more appropriately priced.
Investors should only use this information as a starting point for due diligence. See the following for more information: