BDCs have been experiencing portfolio yield compression that leads to declining income if the company continues to invest in similar assets. This is because of increased competition in a low rate environment with lenders willing to take on lower returns for the same amount of risk. BDCs have been forced to make a decision to either maintain yields through increased leverage or invest in riskier assets. The other option is to cut dividends to match the falling amount of net investment income ("NII"). The good news is that yields are starting to stabilize but there are still loans that are at risk of being refinanced and this article will identify how much risk THL Credit (TCRD) currently has in its portfolio and how this could affect overall yields. The other good news for TCRD is that it has a large amount of growth capital to invest and increase returns. I will also show how much leverage TCRD will need to maintain distributions to shareholders and the potential for increased dividends.
TCRD's portfolio yield has fallen from 14.0% to 12.1% over the last two years but most of the decline has been over the last two quarters due to recent investments in lower yielding assets. Repayments and exits have also contributed to declining yields as the healthier portfolio companies refinance loans at lower rates. The chart below shows the decline in yields for both new originations and the overall portfolio.
However it is important to note that the originations from Q2 2013 to Q3 2013 increased from 11.1% to 11.9%. This seems to be an industry-wide occurrence with many BDCs reporting stabilizing yields such as Fifth Street Finance (FSC) that yesterday announced "The stronger originations, combined with maintaining target leverage, and a stable weighted average yield on debt investments provides confidence in future net investment income per share that we expect should meet or exceed the current dividend level." This is huge win for FSC and its shareholders after cutting its dividend last quarter.
Even though yields may be stabilizing TCRD still has the risk of refinancings and prepayments in its portfolio. The following table is from my "TCRD: January 2014 Report" and shows the loans that I have identified as having higher prepayment risk due to higher yields. I have not included the two investments that are currently on non-accrual status (C & K Market and Express Courier) or any loans that were originated in 2013. The total fair value and cost of the higher risk loans is around $131 million which is about 23% of the portfolio at a weighted average yield of 14.3%. These loans account for almost 25% of TCRD's total income.
What does this mean for TCRD?
Obviously all of these loans will not refinance right away but most likely over the next few quarters depending on rates, health of the portfolio company or fees related to prepayment. I looked at a few scenarios assuming all the loans were replaced at lower yields to see how the total portfolio yield might be impacted. The following table shows three scenarios of the loans being refinanced at various rates:
There is a chance of TCRD's portfolio yield falling to as low as 11.0% to 11.6%.
TCRD has plenty of growth capital to make up for lower portfolio yields. The table below shows each BDC into two groups based on pricing multiples of net asset value ("NAV") because BDCs such as Hercules Technology Growth Capital (HTGC), Triangle Capital (TCAP) and Main Street Capital (MAIN) with the highest multiples can raise cash at a premium and usually with a lower cost of equity capital (dividend payments) for portfolio growth. TCRD and Fidus Investment (FDUS) top the list of higher priced BDCs for the amount of growth capital that could be used to grow the portfolio and income without the need to issue additional shares giving them a higher potential of increasing EPS. This is a key advantage in an environment of declining yields. It is important to note that larger and more mature BDCs such as Ares Capital (ARCC), Prospect Capital (PSEC) and Apollo Investment (AINV) have less growth potential as a percentage of their current portfolios due to size with the exception of American Capital (ACAS) with low amounts of leverage and a large amount of cash.
What does this mean for investors?
As an investor in TCRD I wanted to see what the potential impacts were to NII as yields decline and if there was the potential for future dividend increases. The CEO stated on the last earnings call "I think our leverage will continue to be in that 0.6, 0.7 range, consistent with a junior capital bias to the portfolio". As of September 30, 2013 its debt-to-equity ratio was 0.28. The following table shows the impacts to dividend coverage at three different yield levels and three different debt-to-equity ratios.
I believe management will be watching new originations along with prepayment activity to gauge the amount leverage and increases to dividends using a similar methodology. This would indicate that even at the lowest yields with leverage of 0.65 TCRD could still raise its dividend by almost 10% or maintain a cushion and continue to pay special dividends with excess income. Either way TCRD has adequate dividend coverage. For more information on TCRD regarding interest rate sensitivity analysis, potential equity offerings, revised rankings, pricing, projected earnings and total return, and associated risks please see my "TCRD: January 2014 Report". Investors should only use this information as a starting point for due diligence. See the following for more information: