This article is a follow up to "The High-Yield BDC Portfolio" from Q3 with updated allocations and investments for a BDC portfolio with an annual dividend yield of over 12% and the potential for capital gains. Currently, the four BDCs for the best high-yield BDC mix are Prospect Capital (PSEC), UBS 2X Leveraged Wells Fargo BDC (BDCL), Medley Capital (MCC), and TICC Capital (TICC). Fifth Street Finance (FSC) is not currently part of this portfolio due to the most recent dividend cut and I do not expect it to cover dividends until March 2014 as discussed in "FSC: Time to Buy or to Sell?".
In my article, "A BDC Investment Philosophy And 4 Portfolios," I discussed what BDCs are and why I see them as good investments as well as four different approaches to investing in BDCs, taking into account various investor needs. Out of the 25 BDCs that I follow, I selected the best BDCs for each portfolio type along with recommended weightings. The five different portfolios that I cover are:
The High-Yield Portfolio
This portfolio is for investors that are willing to take on a little more risk with less stock price 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 high-yield portfolio that is slightly less risky can adjust the weightings higher for MCC, and lower for BDCL, but reducing the overall dividend yield.
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Recent Portfolio Results
In my "BDC Portfolios Update: Q4 2013" I discussed the 'total returns' for each of my suggested portfolios with the high-yield group having the highest amount of dividends earned but the lowest amount of stock price appreciation. This should be expected due to the high amount of dividend income which is more of a 'bird in the hand' investing philosophy compared to waiting and hoping for more. I believe that investors should take into account much more than just the current yield including net asset value ("NAV") and dividend stability.
The table below takes into account the stock price appreciation and dividends earned for the first two months of Q4 to come up with total return to investors. The S & P 500 appreciated 7.4% plus 0.3% in dividends for a return of 7.7% during this period compared to the average BDC with around 6.3%. My five suggested portfolios all performed better than the average BDC and were inline or better than the S & P 500 with the exceptions of the 'High-Yield' and 'Risk Averse' portfolio.
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.
- Profitability (dividend coverage, fees, NAV and EPS growth)
- Risk (portfolio quality and vintage, rate sensitivity, diversification, volatility)
- Return (sustainable, consistent, growing)
- Analyst Opinions (outlook, price targets)
- Valuation (NAV, P/E, growth rates, total return)
The table below does not actually contain whole numbers and the totals might be different (by 1) due to rounding:
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As expected, this portfolio has a higher return compared to most but with average amounts of risk, profit and analyst recommendations.
UBS 2X Leveraged Wells Fargo BDC
BDCL is an ETN based on the Wells Fargo Business Development Company Index. There are many issues with investing exchange traded funds such as capitalization and liquidity limits as well as tracking fees. With this fund there is also the added risk of 2X leverage, roughly equating to double the gains or losses in the BDC index but this is what pays the 14.0% yield. The top six holdings account for over 50% of the fund as shown in the chart below:
This is a levered fund with twice the risk of investing in the average BDC. Risk is great in bull-markets and not your friend in bear-markets.
Higher yield BDCs sometimes have dividend coverage issues resulting in dividend cuts or reductions in NAV which is why it is important to understand if the dividends are sustainable, ideally through net investment income ("NII") and special dividends covered by realized capital gains. All 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 FSC which is why it currently is not part of this portfolio.
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Ultimately, these companies should be able to sufficiently cover dividends with NII. PSEC 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 of these BDCs have had NAV per share growth or stability compared to other higher yield BDCs as shown in the table below:
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The NAV decline rates for MCG Capital (MCGC), BlackRock Kelso Capital (BKCC) and KCAP Financial (KCAP) are some of the reasons for not including these BDCs in the high-yield portfolio. However KCAP has been improving and with one of the highest yields in the industry that could be covered in the coming quarters I will keep it on the short list for future consideration.
Along with high-yield usually comes higher amounts of 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 5.4 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.
Obviously, this portfolio has a higher than average dividend yield at 12.2% compare to the current average of 9.2%. At this point I would not expect to see much growth in dividends paid, with the exception of MCC.
Analysts have relatively higher opinions for some 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:
As you can see, PSEC, MCC, TICC, and FSC are priced slightly lower than the average BDC contributing to their currently higher yields.
In a healthy market, riskier BDCs such as TICC and PSEC usually payoff especially with higher yielding investments like CLOs. For the high-yield investor, I believe this is a solid portfolio with a dividend yield of over 12% 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 (especially for FSC and KCAP), 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) but 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: