- Historically BDC CEFs offer the potential for both an increase in portfolio cash flow and total return during a period of rising interest rates.
- We reviewed how loan-based BDCs did when 30 day LIBOR rates rose +4.4% from 1.097% on March 1, 2004 to 5.493% on September 30, 2007.
- We looked at how high yield and loan traditional CEFs did over the same time period; on average there was a +20% performance relative alpha and +9% yield relative alpha.
We constantly hear from investors seeking ways to maintain yield or add to their portfolios' income potential as well as develop an investment strategy for a future rising interest rate environment. We think Business Development Company Closed-Ended Management Companies (BDC CEFs) can be a key part of this strategy and CEF Advisors already employs 4% to 12% exposure in these funds for most client accounts.
In the past few years many BDC CEFs have increased their portfolio exposure to floating rate investments and have generally used Fixed Leverage Cost to finance the investments. We see this as a very positive trend for retired investors looking to build and manage an income-oriented portfolio that they should have trouble out-living. However, we find that BDC CEFs require more research to understand than their traditional CEF cousins and are not as homogeneous as traditional CEFs.
BDC CEFs are not new investment structures. They are regulated investment companies, created by Congress in 1980 to help spur investment in smaller companies and give investors access to strategies previous only available to accredited or high net worth investors. BDC CEFs generally make loans and or invest in smaller US companies and pass on the interest to shareholders as income in a similar fashion to REITs and MLPs.
BDC CEFs are "flow through" vehicles for tax purposes and pay no corporate taxes as long as they distribute 90% of their annual income to shareholders. We follow them alongside our work in traditional CEFs as they meet our firm's CEF definition: active portfolio management, fixed capital structure and investor liquidity through listing on exchanges. As the lending market from traditional banks has waned, BDC CEFs have increased lending to both growing and distressed companies. This can be a very profitable business when done well on a consistent basis. We started actively tracking BDC CEFs in our weekly CEF Universe data in March of 2014 and currently record 45 data points per fund.
According to our CEF Universe data, there are currently 50 BDC CEFs that have a combined market cap of $36.5B vs. $269B in the traditional CEFs market. BDC CEFs currently show an average yield of 9.60% on a forward-looking basis, with 62% yielding over 8%, and they trade at a current discount of -2.34% vs. a one-year average of a +0.40% premium. Average trade liquidity is significantly higher for BDC CEFs than traditional CEFs, with $5.9M a day in 30-day average trade liquidity vs. the average taxable closed-end fund showing $1.4M a day in liquidity. 41 of the 50 BDC CEFs are primarily debt/loan focused, which for comparison purposes we will compare to the 67 loan and high yield bond traditional CEFs.
The table below demonstrates the difference in the two fund structures. Debt BDC CEFs trade about 5% higher to NAV on a relative basis, yield about 2.5% more, employ about 25% more leverage, have almost 6X the liquidity and have about 65% more price volatility. The market prices and NAV total returns of loan-focused BDC CEFs have lagged about -4% over the past year, but we think they are better positioned for the next trend in interest rates on a yield and total return basis.
According to an August 2013 Fitch Research report on BDC CEFs, floating rate instruments represent 35% to 80% of total investments, vs. fixed interest rate assets, for the BDC CEFs that Fitch provides rating coverage. For these BDC CEFs an increase in interest rates will add to future net investment income. This may allow the funds to increase yields and reduce the risk of principal loss as loan rates reset higher. It should be noted that for most funds, LIBOR will need to rise about 1.00% for them to experience this positive scenario. As more BDCs have utilized fixed-rate funding vehicles, they have become less reliant on floating revolvers to fund investments. As rate increases are not a perfectly positive scenario for any debt investment, we believe the BDC underwriters have likely factored the risk of rising rates into their loan terms when they originate deals in the current environment. While rising rates will increase the cost of the loans, we feel that it will coincide with a growing economy, a trend that should be positive for many holdings and less of a drag on performance.
Traditional CEFs employ leverage and generally use 25% to 40% leverage ratios on their holdings. We calculate leverage, for traditional CEFs, as total debt borrowed divided by total portfolio assets. However, most BDC CEF analysts calculate BDC CEF leverage as total leverage divided by net assets vs. gross assets. BDC CEFs can lever at higher levels than traditional CEFs. When we use our traditional CEF method of calculating leverage ratios, to get a comparable figure for BDC CEFs, it currently equals a maximum figure of 50%, with 30% - 49% being a normal BDC CEF leverage ratio range. It is important to note that BDC CEF leverage is still lower than the leverage typically utilized by REITs and bank stocks. We like the benefits of leverage for loan-focused BDC CEFs and try to remind investors that leverage is simply an accelerant for investment results. It will magnify the profits or losses, which is why good management is an important factor to consider when choosing loan-focused BDC CEFs for your portfolio.
As BDC CEFs investors already know, on February 24, S&P announced it would remove BDC CEFs from its indexes to avoid showing BDC CEF fees in expense ratios and on March 3, Russell made the same announcement. While this pushed many BDCs to lower prices, by about -5%, we did not see any long-term material changes to how BDC CEFs operate and it gave many investors an opportunity to buy into many of the liquid BDC CEFs at 5%+ lower price points than were available during the first quarter of 2014. One benefit was the fixed capital nature of BDC CEFs which allowed for the portfolios holdings to not be impacted by the event and so there was no forced selling of assets due to redemption pressures common in the open-end fund structure.
The S&P and Russell indexes decision was wide spread as it impacted 33 BDC CEFs. For investors that are attracted to buying quality assets on sale through the closed-end fund structure, this event created an attractive entry point which reminded us of what Sir John Templeton used to say about investing; you buy when there is "blood in the streets." We think it will take some time for prices to climb back to valuations seen prior to the announcement, but we believe the upside far outweighs the downside in a portfolio of well-picked BDC CEFs.
Why should the BDC CEF sector do well in a rising rate environment? BDC CEFs generally depend on the internal health of the American economy. We have seen solid 2% GDP growth, excluding the first quarter of 2014, despite the challenges of Washington politics and international conflicts. BDC CEF loans should generally perform well if we continue to see 2%-3% GDP growth for The US.
How did BDC CEFs handle a previous rising rate environment? There were 5 loan-based BDC CEFs in existence from March 1, 2004 to September 28, 2007, when 30-day LIBOR went from 1.0973% to 5.4927% (a 4.40% increase) over a period of 43 months. This is the most pronounced rise in rates in recent history, and one that is potentially similar in nature to the increase in rates currently forecasted for 2015 or 2016. A data table below notes the 5 BDC CEFs reviewed.
Even though it is a small sample size, each BDC CEF has positive total return over the time period and there were only small decreases to the yields of two of the funds. ACAS, which had the largest reduction in yield, also had the highest total return overall. We think this data suggests the BDC CEF sector is poised for higher yield and total return performance when rates eventually rise. This may take some time, but we still believe the sector can do well while we wait for rate increases. Of course, you will need to be sure to be in well-managed BDC CEFs as poor loan performance will hurt NAV and income in any interest rate environment.
To compare how BDCs performed vs. high yield and loan traditional closed-end funds, we ran data over the same time period for the 34 funds.
With more than +20% relative alpha, and an almost +9% relative increase in future indicated market yield, it is very compelling to include BDC CEFs in an income portfolio as they have historically done better on average than their closest peer CEF cousins in yield and performance.
As mentioned before, BDC CEFs have been able to take advantage of mostly fixed-rate financing, which will keep their cost of capital low when rates rise. We believe BDC CEFs will also follow the path of acceptance of REITs and MLPs. Both REITs and MLPs have historically experienced short pull backs when rates rise, but eventually performed well for investors in both rising and falling rate environments.
While, in our opinion, this is a positive outlook for BDC CEFs, there are some risks investors need to monitor when buying BDC CEFs. We see four hurdles that need to be overcome:
1. Net asset value is only produced quarterly as the holdings are generally private level 3 assets that require work by CPAs that specialize in private company and security evaluation. This makes NAV less important than with traditional CEFs, which typically produce an NAV daily.
2. BDC CEFs have shown that their market prices are generally more volatile than traditional CEFs. While this can be seen as an increased risk, in our opinion, this is a positive attribute that will reward diligent investors with more opportunities to buy or sell outside of normal trading levels.
3. We don't think indexing works well for BDC CEFs. Individual BDC CEF selection, and timing of an investment, is far more important to our firm, due to the need for strong loan origination and managerial assistance to their portfolio companies to help produce long-term investment success. In our research we have noticed that BDC CEF funds typically have higher dispersions vs. the underlying sector (in our opinion the removal of BDC CEFs by the S&P and Russell indexes was unique). The pricing reacts to positive portfolio and dividend growth vs. just a broad interest in the sector by investors. We researched this by looking at one year market price data on the 67 traditional taxable high yield / loan CEF funds vs. 41 debt BDC CEFs over the previous year.
Source: CEFA's Universe Data June 20, 2014. We used the top/bottom 17 HY/Loan CEFs and 11 Loan BDC CEFs. We removed NHF from the comparison as it has over 50% equity exposure.
The spread from the top vs. bottom quartiles is not only 1.9X greater for BDC CEFs than traditional CEFs, but the average loss of -8.0% vs. gain of +8.4% shows the potential downside of poor BDC CEF selection.
4. Debt BDC CEFs have credit risk similar to traditional high yield bond CEFs as they face the risk of default or bankruptcy for holdings. However, they are often "senior secured" debt, meaning in a default, they will get paid back first before other investors should the company have financial trouble.
We find many investors think of BDC CEFs as operating companies vs. a diversified investment company. This is expected as they file with the SEC like an operating company and have earnings calls, but we found they have the benefits of more diversification than most operating companies and the 40-Act tax-beneficial structure. We think if you look for BDC CEFs with an NAV that has been relatively stable, leverage and loan terms that are favorable, and management teams that are proven, then you have a good opportunity to place a portion of your assets in an 8% to 10% yielding BDC CEF that should perform favorably when rates eventually rise 2%-5%.
Think you might be too late to the table for BDC CEF investing? I recently spend a week in Chicago for Morningstar's 26th Annual Investment Conference. I spoke with my contacts at Morningstar, fund sponsors, fellow investment advisors, and some of the top panelists from the event. Through these conversations, I came to the conclusion that there are still very few investors and financial advisors using BDC CEFs in a meaningful way for their portfolios, especially when you take into consideration that they are a 34 year-old structure. As we work to understand these funds at a higher level, we see that BDC CEFs are still very early in their growth and acceptance stage by investors and we think they are very well positioned to take advantage of the US economic recovery and a rising rate environment.
Additional disclosure: The views and opinions herein are as of the date of publication and are subject to change at any time based upon market or other conditions. None of the information contained herein should be constructed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed. Data, unless otherwise stated comes from our June 20, 2014 CEF Universe service.