Brexit: No High-Yield Panic Yet

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Includes: AINV, BCS, BPOP, OCSL, OFG, PSEC, SALT, SB, SBLK
by: Richard Lejeune

Summary

Analysis of how Brexit impacted some high yield BDC, banking preferred and shipping debt issues.

Some BDC issues held up very well due to moderate balance sheet leverage, lack of international exposure and focus on debt holdings.

Issues dependent on near term access to capital are especially vulnerable.

Brexit anticipation and fear ran high on Friday morning. There was fear of a market meltdown, but also anticipation of picking up some high yield bargains. A record number of Panick Value Research Report members were logged in with eyes glued to the chat board. They were eager to exchange ideas as "flash crash" type bargains materialized. It was a dud. Despite the 600 point plus decline in the Dow, most high yield issues (with a few notable exceptions) held their ground remarkably well. The prospect of "lower for longer" interest rates appears to be offsetting fears of a weaker global economy. Here are some observations on why some high yield sectors and issues might be hit harder than others by Brexit.

Why were BDC issues down much less than banks?

Most BDC investors breathed a sign of relief as BDC issues such as Prospect Capital Corporation (NASDAQ:PSEC), Fifth Street Finance (NASDAQ:FSC) and Apollo Investment (NASDAQ:AINV) only fell about 1% on Friday. This was a far better performance than the banking sector. Many domestic banks fell 5% or more. There were far larger losses for European banks such as Barclays PLC (NYSE:BCS) which plummeted 20%. Why did BDC's fare better than most financial sector peers?

BDC balance sheet leverage is restricted. A BDC's total regulatory debt-to-total equity ratio cannot surpass a 1:1 level. A typical bank has a comparable leverage ratio of 6X to 10X. Less balance sheet leverage means less volatility in this type of market sell-off. BDC's are focused on lending to US middle-market companies. When there are problems in Europe, having less global exposure is a good thing.

Debt tends to be less volatile than equity. The Closed-End Fund Advisors BDC Universe is a useful tool for quickly checking what percentage of a BDC's portfolio is comprised of debt holdings. This may also help to explain why FSC (93% of the portfolio is debt holdings), PSEC (89%) and AINV (85%) fared so well on Friday's Brexit sell-off.

Why did some banking high yield preferred issues hold up so well?

Popular, Inc. (NASDAQ:BPOP) fell 5.4% on Friday, but the BPOPN trust preferred issue dropped less than 1%. The market seems to be saying that the Brexit problems are serious enough to hurt US bank earnings somewhat, but not serious enough to interfere with the payment of preferred dividends. We saw a similar pattern with OFG Bancorp (NYSE:OFG) where the common stock dropped 5.3% on Friday, while the OFG-PD non-cumulative preferred issue dropped less than 1%. The enticing prospect of lower interest rates for longer, seems to be offsetting slightly increased credit risk. Both banks are very well capitalized with a common equity tier 1 ratio of 15.8% for BPOP and 12.3% for OFG. Well capitalized US banks with low European exposure can easily absorb a small hit from Brexit.

Why did some high yield shipping debt and preferred issues sink more than others?

There is concern that a slower global economy due to Brexit will delay the recovery of depressed dry bulk shipping rates. Several shipping common stocks traded lower on Friday, but trading in their related preferred stock and exchange traded debt issues was more mixed. What accounts for these differences?

Scorpio Bulkers Inc (NYSE:SALT) had a modest 2.7% drop while the SLTB exchange traded debt issue actually managed to rally 2.6%. SALT has a key advantage over many of its struggling dry bulk peers. They just successfully completed an equity capital raise. This was fantastic timing. The financial turmoil from Brexit may make it more difficult to raise capital in the months ahead.

Star Bulk Carriers Corp. (NASDAQ:SBLK) had a much sharper 7.5% decline. J Mintzmyer's excellent recent article provides some insight regarding this issue. J argues that SBLK needs to raise capital. This task is now more difficult with Brexit disrupting financial markets. The SBLKL exchange traded debt issue dropped 6.8%. Debt holders would suffer if Brexit interferes with efforts to raise additional capital

Safe Bulkers Inc (NYSE:SB) was down 7.9% on Friday, but the loss was only 2.2% for the SB-PD cumulative preferred stock. The moderate decline for SB-PD may be due to the stock repurchase plan that was just announced on 6/22/2016. This announcement suggests that SB has no immediate need to raise capital.

Conclusions

My Panick Value Research Report is focused on high yield preferred stocks and exchange-traded debt issues with daily alerts. If you have not already joined, this may be a very opportune time to sign-up for the 2 week free trial in the Seeking Alpha Marketplace. Brexit is not all bad for high yield issues. There are some positives such as "lower for longer" interest rates and bargains may become available.

As shown by the examples in this article, some high yield issues and sectors are more affected than others. Companies with an immediate need to raise capital could be in serious trouble. Many BDC's are holding up very well due to their moderate balance sheet leverage, lack of international exposure and focus on portfolio debt holdings. A moderate drop in well capitalized US bank stocks should have very little impact on bank preferred issues. There was very little panic in the high yield sector on Friday, but this was only day 1 of Brexit trading. There may be more surprises in the days ahead. What about other high yield sectors such as the REIT, energy and retail issues? Stay tuned for more articles or try my premium service for real time updates.

Disclosure: I am/we are long SALT,SLTB,AINV,FSC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

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