Yield Versus Risk Part 1: Beaten Down Business Development Companies

by: Philip Mause

Recent action by the Federal Reserve has had the effect of creating an investment environment in which the only way to obtain yield appreciably in excess of the rate of inflation is by assuming risk. This has been a two step process. First, the Federal Reserve announced that short term rates on Treasuries will remain at essentially zero until 2013 - this essentially locks in low rates on Treasuries of short duration. Then, the Fed announced its "twist" program in which funds received by the Fed as short term treasuries mature will be reinvested in longer term Treasuries. This has already lowered rates on 10 year and 30 year Treasuries. This writer has suggested that the Treasury test the market for even longer term bonds of durations of 50 or 75 years and also for consols (perpetual bonds with no maturity date). At any rate, long rates have come down and the window for earning a decent yield by moving out the duration curve is rapidly closing.

If the extension of duration cannot be employed to produce a decent yield, then the only thing left is risk. Credit markets discount the value of risky debt instruments and this gives buyers the opportunity to earn a decent current yield. Investors seeking a decent yield on their portfolios will have to decide how much and what kind of risk they want to assume.

I have written about some of the specialty sectors of the market that produce large yields but have unique characteristics that investors should be aware of. Business Development Companies (BDCs) are subject to special tax rules, which require them to devote at least 90 percent of their earnings to dividends. BDCs do not pay corporate income taxes but BDC shareholders must pay ordinary income tax on the dividends. BDCs are limited as to leverage - debt can be no more than net asset value; this tends to make them much less risky than many other financial institutions. In the 2008-09 time period, some BDCs had assumed considerable leverage and when they had to write down their NAV because some debts became uncollectible, they ran into leverage problems and covenant problems with lenders. For a brief time there was some issue of survival with respect to BDCs like Allied Capital, which was eventually acquired by Ares Capital (NASDAQ:ARCC).

BDCs have generally reduced leverage substantially and now are structured so that considerable asset write off activity would not create a debt equity ratio problem. Asset write downs are of course a possibility if there is a recession but BDCs will not be required to sell off assets at fire sale prices to meet leverage requirements. This dramatically reduces risk - both in comparison with the BDC situation during the 2007-09 time frame and in comparison with other financial companies, which generally employ much greater amounts of leverage. I do not think that the market fully appreciates this change and BDCs have tended to get clobbered when the financial sector gets clobbered. This has opened up some real bargains in this sector.

After each company's name, I list the symbol, Friday's closing price, the 52 week high, the current dividend yield and the price/NAV ratio.

1. Gladstone Investment (NASDAQ:GAIN)(6.89)(8.55)(9%)(.74) - GAIN has no net debt and has had a fair amount of insider buying of late. Its assets include some preferred stock and a small amount of common stock but these positions could be written down substantially before GAIN's book value would decline enough to equal its market cap. So you are not really paying for the preferred and common stock. The company is well managed and has been increasing NAV.

2. Kohlberg Capital (NASDAQ:KCAP)(5.89)(8.71)(12.7%)(.66) - KCAP had serious problems with its creditors during the 2008-09 crisis but these problems are over. KCAP has low leverage and should not experience a repeat of those problems unless it increases leverage. It is well off its 52 week high without any really substantive bad news and it is trading at a big discount to NAV.

3. NGP Capital (NGPC)(6.90)(10.89)(10.5%)(.71) - NGPC is a specialty BDC which provides funding for oil, gas and coal projects. There has been some insider buying. With the sale of a large investment for cash shortly after the close of the last reporting period, NGPC may now be in the position of having no net debt. It is well off its high and should be able to perform well in the future.

4. MCG Capital (NASDAQ:MCGC)(4.09)(7.62)(17%)(.58) - MCGC is both the riskiest and the most promising of the group. It still has considerable debt. It has been going through a transition from making investments (including equity investments) in competitive local exchange carriers to making loans to a wide variety of businesses. It has probably taken most of the hits necessary on its legacy portfolio of telcom assets but there may be a few more. There has been some insider buying of late. The risky aspect is the debt. Although MCGC has somewhat of a cushion before it would run into ratio problems, it is not an enormous cushion. I think management will be able to stay in compliance even if some more write downs are necessary. In time, the income from the investments in debt instruments will continue to grow and ultimately this could be a very rewarding stock.

I wouldn't put all or even 20% of my portfolio in any one of these but there is benefit in investing in a group of these stocks to minimize risk. The dividends may jump around because such a large proportion of earnings have to be sent out as dividends. On balance, I think that these stocks present a promising risk reward profile and I am long all 4 of them.

Disclosure: I am long ARCC, GAIN, KCAP, NGPC, MCGC.

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