Last month, I started a series of articles that solely focuses on the resilience and performances of certain yield-starving instruments during periods of rising rates and yields.
The series started with an analysis of mortgage REITs (REM, MORL, MORT), "mREITs" hereinafter. In total, 40 names across 4 different types of mREITs (Commercial, Residential, Hybrid/Special and Traditional/Agency) have been part of this analysis.
Part I: Residential eREITs
Part II: Data-center and storage eREITs
Part III: Small-cap (*) hospitality eREITs
Part IV: Large-cap (**) hospitality eREITs
Part V: Large-cap (**) healthcare eREITs
Part VI: Small-cap (*) healthcare eREITs
Part VII: Industrial eREITs
Part VIII: Triple-Net Lease eREITs
(*) Small-cap = Below $3 billion market cap
(**) Large-cap = Above $3 billion market cap
It's now time to move to the third segment of yield-starving instruments: Business Development Corporations (BDCS, BDCL, BIZD, BDCZ, LBDC), "BDCs" hereinafter. Unlike mREITs and eREITs, the BDCs coverage is being cut into five pieces based on market caps of the publicly traded BDCs. The 57 names spread out across 5 different categories, solely based on their market caps:
Risk Management And The Market Timing Myth
I've been accused of "market timing" a couple of times before. Last month, in this article, I wrote that:
Neither at the fund nor elsewhere I'm trying to time the market. Instead, I'm either adjusting to the ever-changing landscape or implementing long-term decisions over short-term intervals.
If such radical changes, such as the ones we are witnessing over the past three months, don't cause an investor - any investor for that matter - to (at least) think about the new/extra risks and high level of uncertainty - I wonder how such an investor defines "risk management" because, as far as I am concerned, this investor has no idea what risk management is about.
Adjusting to the ever-changing landscape has nothing to do with market timing. Not only that an adjustment to macro changes is an essential part of risk management but describing such an adjustment as an attempt to time the market is either a misleading statement or, even worse, an acknowledgement of not understanding what basic principles of risk management are.
Yesterday, I read an article that I could easily put my name (and I wish my name was) on it; Lance Roberts is one of my favorites among macro analysts on SA. Lance isn't only a balanced and thorough writer, but he is also brave/genuine enough to express unpopular views in a very elegant, easy to understand, manner.
In his last piece, "You Can't Time The Market?" Lance is claiming the following:
It never ceases to amaze me that investors still believe that somehow they can invest in a portfolio that will capture all of the upside of the market but will protect them from the losses. Despite being a totally unrealistic objective this "fantasy" leads to excessive risk taking in portfolios which ultimately leads to catastrophic losses. Aligning expectations with reality is the key to building a successful portfolio. Implementing a strong investment discipline, and applying risk management, is what leads to the achievement of those expectations.
Along his article, Lance is using the work of Brett Arends and a study conducted by Javier Estrada to show that the "You can't time the market" myth is only half of the story while the other (perhaps more important) half is being ignored/hidden by Wall Street intentionally:
The reason that the finance industry doesn't tell you the other half of the story is because it is NOT PROFITABLE for them. The finance industry makes money when you are invested - not when you are in cash. Therefore, it is of no benefit to Wall Street to advise you to move to cash.
Lance is using the below chart to show that even by only using a very basic form of price movement analysis, e.g. a simple moving average, investors may get signal warnings ahead of/during periods it would be wise/warranted to reduce the level of risk within one's portfolio:
Lance concludes with the following important message and action items:
I am not implying, suggesting or stating that such signals mean going 100% to cash. What I am suggesting is that when "sell signals" are given that is the time when individuals should perform some basic portfolio risk management such as:
- Trim back winning positions to original portfolio weights: Investment Rule: Let Winners Run
- Sell positions that simply are not working (if the position was not working in a rising market, it likely won't in a declining market.) Investment Rule: Cut Losers Short
- Hold the cash raised from these activities until the next buying opportunity occurs. Investment Rule: Buy Low
By using some measures, fundamental or technical, to reduce portfolio risk by taking profits as prices/valuations rise, or vice versa, the long-term results of avoiding periods of severe capital loss will outweigh missed short term gains. Small adjustments can have a significant impact over the long run.
Not only that I couldn't say it better myself, but I find this article to be a must read for anyone who is convinced (or busy with self-convincing) that such type of risk management has, one way or another, anything to do with market timing.
Risk management is all about constantly assessing the market, the potential risks and rewards. Such an assessment may lead an investor to reduce/increase the level of risk/s, but that has nothing to do with "market timing" rather with a sound analysis of the risk/reward that is being offered at a given point in time.
Retrospectively, we are all very clever because we may judge an investment decision based on its performance. Risk management is about judging an investment decision before it's being taken. It's the reasonable judgement and the quality of the risk management that determine the well-being of a portfolio, not its performance!
Nobody likes to lose money and a positive performance is crucial but for itself, performance can't and doesn't measure the quality of risk management. Proper risk management may lead to decent performance, not vice versa!
Do you judge any of the following as sound-reasonable investments?
1. Betting on a single number while playing the roulette?
2. Picking a stock out of the pink-sheets?
3. Jumping into a market that is clearly super-rich and overvalued?
Source: Morgan Stanley
Sure thing, any of these examples may end up with a profit, perhaps a huge profit. Nonetheless, the end result - as large as it may be - won't change the lousy risk/reward profile of any of these possible investments prior to taking it!
Although risk management is an ongoing process and any investment should be assessed regularly, this process starts prior to making an investment decision and it can't be judged by the end result of that investment decision. Surely, in a perfect world a sound risk management should lead to sound performance but that is neither guaranteed nor operates in a linear line.
BDCs Are Better Positioned Than REITs
My current risk management analysis dictates that I should be neutral (at best) when it comes to equities and negative when it comes to credits. On the other hand, I still like many names - especially those that are part of my A-Team - so I'm not adopting a "let's sell everything" approach rather a long-short, more balanced, approach. I'm doing so by hedging (selling short) the H-Team against my long A-Team positions.
In total, there are six BDCs that are part of my A-Team:
- Main Street Capital (NYSE:MAIN): Part I
- Ares Capital Corporation (NASDAQ:ARCC): Part II
- Gladstone Investment Corporation (NASDAQ:GAIN): Part VI
- Newtek Business Services, Inc. (NASDAQ:NEWT): Part VIII
- Hercules Technology Growth Capital (NASDAQ:HTGC): Part IX
- Prospect Capital Corporation (NASDAQ:PSEC): Part X
Each and every one of those has a portfolio that is mostly linked to floating-rate loans. This feature is one of the most important features I'm looking for when holding a BDC or a REIT these days, while expecting higher (short-term) rates and higher (long-term) yields.
BDCs, eREITs and mREITs are not the only instruments that benefit from a growing economy. Principally, any stock and any company does. What differentiates this trio is that they respond differently to rates, yields and credit spreads.
In a very simplistic way, here are the implications of these features on the three yield-starving segments:
|Higher (Short-Term) Rates||Higher (Long-Term) Yields||Widening Spreads (Steepening Yield Curve)|
|Positive (Floating-rate loans generate more income)||Less meaningful but surely not negative (Positive if there are loans/assets linked to longer-term yields)||Positive (Pay low-fixed rates, earn higher-floating rates)|
|Negative (More expensive self-financing)||Mixed effects: Negative for BV (short term), Positive for NII (long term, assuming widening spreads)||Positive (Better profitability out of a wider NII)|
|Negative (More expensive self-financing)||Negative (More expensive mortgages/tenants financing, Lower valuations of tangible assets)||Less meaningful but surely not positive|
This simple table, comparing the effects of rates, yields and spreads on BDCs, mREITs and eREITs is basically all you need to know. Naturally, there are more moving pieces/factors that should be taken into consideration, but if you understand the basic concepts, all is left to do is to decide which camp you belong to.
On one side, there are those who believe that yields have run their course and that there is little upside from here or even a significant downside, possibly back to 2% yield the US Treasury 10-Year ("UST10Y"), or even below that.
On the other side, you have those that expect the UST10Y to cross the (crucial, per Bill Gross of Janus Capital) 2.6% level, on its way to the 3% (crucial, per Jeffrey Gundlach of DoubleLine Capital) mark.
If you read my high convictions for 2017, you already know which camp I belong to. As such, my main message is for you to watch out, pay close attention to the macro environment, and remain very mindful of risk management at all times!
The next part of this series, Part IV, will focus on BDCs with a market cap of $100-200 million.
In total, we now have 5 categories of BDCs (sorted according to order of publication):
- Market cap greater than $1 billion (11 names): ACAS, AINV, ARCC, CODI*, FSIC, GBDC, HTGC, MAIN, NMFC, PSEC, TSLX
- Market cap greater than $300 million and up to $1 billion (13 names): BKCC, FDUS, ECC*, FSC, GSBD, MCC, PFLT, PNNT, SLRC, TCAP, TCPC, TCRD, TICC
- Market cap greater than $200 million and up to $300 million (11 names): CPTA, CSWC, FSFR, GAIN, GLAD, MRCC, NEWT, OXLC, SUNS, TPVG, WHF
- Market cap greater than $100 million and up to $200 million (13 names): ABDC, ACSF, CMFN, GARS, GECC**, GSVC, HRZN, KCAP, JMT*, MVC, OFS, SAR, SCM
- Market cap smaller than $100 million (9 names): EQS, FULL**, HCAP, MFIN, OHAI, RAND, SVVC, TINY, XRDC
*While technically this is not a BDC, the company operates similarly to few/many BDCs, distributes a steady dividend periodically and keeps the dividend yield in line with levels that most BDCs pay out.
**Acquired the assets of Full Circle Capital and began trading as Great Elm Capital in November 2016
Over the past five years, we have witnessed three periods of rising rates/yields:
- Period I: 4/26/2013 - 12/27/2013
- Period II: 1/30/2015 - 7/3/2015
- Period III: 7/8/2016 - 12/15/2016
For each type/classification of BDCs, there are three charts that show the performance of the relevant companies (belonging to the sub-group) during the three periods - three charts per group, one chart per period.
Then, the average return for each group during each period was calculated in three different ways:
- Average based on all the observations (of all the companies that were publicly traded) during the period.
- Average that excludes the best and worst observations that were recorded during the period.
- Median or average of the median (if it comprises two observations).
By excluding the best and worst, we "soften" the "bumps" that may occur due to specific/extreme news/events that may have affected a certain company. In other words, we avoid temporary "noise."
After receiving three different averages, I calculated an equal-weighted average for all three averages. By doing so, I believe the data is more reliable and less affected by temporary specific news, events or returns that one or two companies may have gone through the examined period.
Bear in mind that this is a relative drill - an attempt to point out at specific types and names of BDCs that perform more or less favorably during periods of higher rates/yields. Therefore, more than an accurate mathematical-scientific result, I'm mostly interested in presenting the trends and the different performances of various types of BDCs. That way, we will be able to draw better conclusions regarding each sub-group's relative strength compared to other sub-groups within the BDC segment.
Before presenting the charts for the specific BDC sub-group that this article is focused on, it's worthwhile to take a closer look at how the main - best comparable ETFs have performed during the three periods (of higher rates/yields) that we examine:
- Equities: The SPDR S&P 500 Trust ETF (SPY)
- High Yield: iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG)
- mREITs: iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM)
- eREITs: Vanguard REIT Index ETF
Period I: 4/26/2013 - 12/27/2013
Interestingly, not only did BDCs outperform both types of REITs, they also managed to deliver a very nice positive return of ~7.5%. It's worthwhile noticing that HYG, which also posted a positive return, albeit small, are more closely correlated to the HY space rather to their yield-starving counterparts - eREITs and mREITs.
The first examined period's results definitely strengthen the perception that rising rates/yields are actually beneficial for BDCs. Let's see how things look during the second period of rising rates/yields:
Period II: 1/30/2015 - 7/3/2015
Once again, we see a very similar picture: While both eREITs (mostly) and mREITs struggle, BDCs managed to end the second examined period with a positive return of ~2.1%, not too far away from the ~1% performance of HYG (though more than doubling it). The second period revalidates what we've experienced during the first period. So far so good, but will the third period reaffirm these interim conclusions?
Period III: 7/8/2016 - 12/15/2016
Ladies and gentlemen, we have a "full house!" Three periods, three positive total returns, three decisive results of clear outperformance. With its circa 11% return, the BDC segment proves it's not only resilient, but actually benefit from periods of rising rates/yields.
Looking at the three periods of rising rates/yields, the performance of BDCs (7.5%, 2.1%, 10.7%) is miles ahead that of mREITs (-16.9%, -3.36%, 4.78%) and, especially, eREITs (-9%, -10.6%, -8.72%).
As a matter of fact, the combined ~20.3% return of BDCs during the three periods of higher rates/yields is much better than the combined performance of the HYG, and it's not too far from the combined return posted by the SPY.
Clearly, this should come as no surprise to anyone who tracks and understands BDCs. I have written a couple of times about the relationship between rates/yields to BDCs' prices. The bottom line here is that these two are positively correlated, and the former is beneficial for the latter.
Now, knowing that BDCs are able to perform during periods of increasing rates/yields, the question that remains is: Can we identify specific BDCs, names or sub-groups, that perform better than others during periods of rising rates/yields?
Specific BDCs - Charts and Analysis
Within the BDC segment, the sub-group that this article is focusing on is BDCs with market caps greater than $1 billion ("BDCw300M>MC>200M")
Chart 1: BDCw300M>MC>200M, 4/26/2013 - 12/27/2013
Please note the following:
(*) FSFR and CPTA only started trading in July and September 2013, respectively. Their performances during (the relevant period out of) the second examined period, -3.95% and 7.76% respectively, are included in the below calculations.
(**) This chart contains no data regarding TPVG, because this stock started trading only post the examined period.
(***) Although NEWT only converted from a regular C-corp into a BDC in November 2014, its performance during the examined period was taken into consideration as is.
- Average including all observations: 11.14%
- Average excluding best and worst observations: 8.99%
- Median: 9.08%
- Average performance of all three averages: 9.74%
While the BDCs with market caps of $200-300M didn't perform as well as BDCs with market caps >$1bn during the first examined period, they did better than BDCs with market caps of $300M-1B. Nonetheless, when we talk about 9.74%, 13.11% and 7.98% over a period of eight months there's little room to be too picky.
My beloved NEWT led the way here with an unbelievable 51% gain. I'm sure that few readers would now (just like the sergeant at "In The Army Now" by Status Quo did) stand up and fight this performance, claiming that since NEWT (during the first examined period of rising rates/yields) wasn't yet a BDC, this performance shouldn't count in. Well, let me calm you all down by saying that this performance was neither unique nor a one-off when it comes to NEWT during periods of rising rates/yields. Wait and see for yourself...
In total, 8 out of the 10 names (exactly 80%) recorded positive total returns with five out of these ten names recording double-digit total returns: NEWT (50.98%), CSWC (23.02%), OXLC (15.6%) GAIN (14.49%) and GLAD (10.50%).
Two names, MRCC (-11.5%) and FSFR (-3.95%) posted negative total returns and (spoiler alert!) things don't get much better for these names, especially not for the latter. We'll get back to it shortly...
Chart 2: BDCw300M>MC>200M, 1/30/2015 - 7/3/2015
- Average including all observations: 9.95%
- Average excluding best and worst observations: 9.11%
- Median: 8.73%
- Average performance of all three averages: 9.27%
The second examined period of rising rates/yields saw the sub-group posting a similar performance to the first period. Nonetheless, while the first period span over eight months the second period length is only five months. Therefore, in annualised terms, the second period's performance was much better than the first period.
Once again, it's NEWT and then the rest... With a stunning 34% positive total return, NEWT almost doubled the performance of WHF, the second best-performing stock during this period.
Just as was the case during the first period, we have two names that posted negative total returns and once again it's FSFR that make it into the wrong list. Although CPTA barely captured the worst-performing title for the second period, FSFR was only 0.23% ahead. Nothing to be too proud of.
Nine names (out of eleven) posted positive returns, out of which five names recorded double-digit total returns. Aside of NEWT, it's worthwhile mentioning CSWC, GAIN and GLAD that are doing so for the second time in a row. For those of you who don't know that, GAIN and GLAD are part of the Gladstone group of companies, that also include two REITs: LAND and GOOD. I was a holder of GLAD (sold out a couple of months ago) and I'm still a happy camper of GAIN, another A-Team member.
Chart 3: BDCw300M>MC>200M, 7/8/2016 - 12/15/2016
- Average including all observations: 15.80%
- Average excluding best and worst observations: 16.13%
- Median: 16.81%
- Average performance of all three averages: 16.25%
Bang!!! 16.25% over a period of little over five months - that's almost 41% annualised! - is something that we haven't seen yet from any other sub-group, neither a BDC nor a REIT, during any of the periods. This is not (only) the "Big Bang Theory" but (OTCQB:ALSO) the "Small BDCs Mystery" which turns a "Superb" performance onto a "Phenomenal" one.
One name, CPTA, "succeeded" in ruining the "all positive" sheet but even its -4.09% couldn't hurt the fantastic, i.e. phenomenal, performance of this sub-group during the third and final examined period of rising rates/yields.
Eight names (out of eleven), that's circa 73%, posted double-digit positive total returns with (guess who?) NEWT, for the third time in a row, leading the pack. After the 50.98% and 34% performances during the previous periods, NEWT "calmed down" with a 32.77% performance. Remember the "stand up and fight" regarding the first period in which NEWT wasn't a BDC yet? Well, guess what? It doesn't really matters! As impressive as the first period's 51% total return is, NEWT is king of BDCs, with or without counting the first period's result in.
Like NEWT, three other names - CSWC, GLAD and GAIN - managed to post a perfect streak of double-digit positive total returns. OXLC and WHF only missed out on that achievement due to one less-favourable period but they still ended up with double-digit positive total returns on average.
CPTA, MRCC and SUNS under-performed not only this period but also overall. FSFR finally managed to perform positively, recording a double-digit positive total return during this period; well, even a broken clock shows the right time twice a day... Nevertheless, this period was the promo to what happened shortly after:
Not as bad as FSC but not as good as it gets...
...or should get...
BDCw300M>MC>200M - Main Results and Findings
First of all, let's put the data we have gathered from the above charts into a table:
There are a few immediate results that catch the eye regarding BDCw300M>MC>200M performance during periods of increasing rates/yields:
- It's only getting better over time: From "very good" (The 9.74% is ~15% annualized), through "superb" (The 9.27% is ~23% annualized), to "phenomenal" (The 16.25% is ~41% annualized). The average of all averages of the three annualized returns is ~24%. Superb!
- Although the success rate (of positive returns) is <3% lower than that of BDCs with market caps greater than $1bn, it's higher by >3% than the success rate recorded by BDCw1B>MC>300M. Nonetheless, excluding the results posted by two names (FSFR and CPTA) that are responsible for two negative performances each, the success rate of BDCw300M>MC>200M would have jumped to 96.15% (25 out of 26 observations).
- Eight out of the eleven names succeeded in recording positive returns through each and every period. All of those but one (NASDAQ:SUNS) also succeeded in delivering double-digit positive total returns, on average: While TPVG did so over (the last) two periods, NEWT (39.25% return on average), OXLC (17.36%), CSWC (17.23%), GLAD (16.64%), GAIN (16.46%) and WHF (12.76%) did so over all three periods.
- Four names did more than that, posting double-digit positive total returns on each and every examined period of rising rates/yields, as a standalone: NEWT, CSWC, GLAD and GAIN. OXLC and WHF missed on completing the same streak only due to one less impressive result during one of the second and first period, respectively.
- CPTA was the only name to finish this analysis with a negative total return on average, although (even here) we only talk about a mere -1%.Other under-performers were MRCC (with a 0.51% return on average), FSFR (1.06%) and SUNS (3.72%). MRCC suffered from a very bad jump-off (-11.5% during the first period) that was most likely a result of the end to the lock-up period following its IPO in late October 2012. This period finished just as the first examined period of rising rates/yields started.
- NEWT. What else can I say about a stock that posted such an amazing streak of returns during the three examined periods of rising rates/yields? Not much indeed but I'll give it a shot anyhow. Since 3/31/2016, when the A-Team been launched, NEWT has delivered a stunning total return: As you can see about 70% of the total return are a result of the price appreciation while 30% attributed to the dividend attributions/yield. NEWT still pays ~10% a year and the current environment (economy etc.) is quite favorable to its activities.
- GAIN. Although its past results (during period of rising rates/yields) aren't as impressive as NEWT, GAIN has nothing to be shy of:
The allocation between price appreciation to dividend distributions is almost identical to that of NEWT but the total return is even higher! I believe that further gains can be produced out of GAIN. The company's VC-style of business is perfect for the pro-entrepreneur environment that we are most probably going to face in 2017.
The bottom line is very easy and very clear:
- Over the past few months, I've explained a couple of times why I believe that mREITs are better positioned than eREITs. Over the last couple of months, I've also written many times that BDCs are better positioned than REITs. If you haven't understood why do I say so and where I'm coming from - this article clarifies the matter and clears the way. BDCs are not risk-free instruments, not at all, but it's important to know which hand to play when; 2017 seems like the right time to play the BDCs-hand.
- Over the past few months, I've explained a couple of times why I believe that many eREITs are overvalued. Although most BDCs trade at or near their 52-week highs, it's safe to say that (unlike eREITs) BDCs are not overvalued. The growing economy, positive sentiment and near-term possible legislation create an almost perfect setup for BDCs to keep flourishing. Although BDCs aren't immune to losses, especially if the market as a whole goes through a correction, they still offer an attractive risk/reward profile.
- BDCs with market caps between $200 to $300 million are the real deal. It's no wonder that among my 12 BDCs holdings, 1/3 belong to this sub-group (and 5/12 belong to the BDCwMC>1B sub-group but that's less surprising). While such market caps are, no doubt, small, investors should bear in mind that the BDCs belong to a growing-developing segment. Even the largest BDCs still have relatively small market caps and until this segment grows further - anyone who wishes to invest into it must accept the built-in smaller-size feature. Just like the famous quote says: "Great things come in small packages"
- Looking at the results of this analysis and comparing those to my personal holdings I'd say that while NEWT and GAIN are proven names with >10-year of track-record, TPVG and MRCC belong to the growing-developing names with <5-year of track-record. I like this combination and I strongly recommends to those who would like to get exposed to the BDCs-segment to diversify their holdings not only within the portfolio, any portfolio, but also within the segment. Diversification is a key element in an efficient risk management process.
- It's easy to pick winners among this sub-group; almost any number wins. I believe that this sub-group specifically and the series as a whole, thus far, show that more than picking the winners it's important to avoid the losers. Just like FSC was singled out among the BDCw1B>MC>300M, CPTA and FSFR seem like the names that one would be better off without.
- Only 5 observations (or 15.63%) out of the total 32 observations of BDCw300M>MC>200M ended up with negative returns. If we exclude the results of CPTA and FSFR from the data this (negative) rate falls to 3.85%. Furthermore, 18 out of the 32 (and 17 out of 26, if we exclude CPTA and FSFR) ended up with double-digit positive total returns. Putting it differently, if you invested randomly in this group during periods of rising rates/yields - you had very good chances of fetching a very lucrative return. The average return of the 18 observations was 21.31%.
- Eight names out eleven completed this analysis with a clean sheet, i.e. all observations ended up with positive returns. Out of which: Seven out of these eight names ended with double-digit positive total returns, on average. Out of which: Four out of these seven names succeeded in posting double-digit positive total returns during each and every examined period of rising rates/yields (with two other names very close of doing the same). Chapeau!
This is only the third piece out of a five-part series covering BDCs during periods of rising rates/yields. As such, please do bear in mind that the above-mentioned are only interim conclusions. Final-decisive conclusions regarding the entire BDCs segment will be drawn only when this five-part series comes to an end.
Only after analyzing all types of BDCs will I be in a position to better differentiate between right ("resilient BDCs") and wrong ("under-threat BDCs") when it comes to investing in BDCs during periods of rising rates/yields.
One should always be mindful of changes in the landscape that may change the attractiveness of a certain investment/instrument. Nonetheless, as it looks now, there won't be many "wrong-doers" among the BDCs segment during periods of rising rates/yields.
BDCs are for real! Bear with me, Do your own due diligence, Create wealth and Stay tuned!
Disclosure: I am/we are long ARCC, GAIN, HTGC, NEWT, PSEC, NMFC, PNNT, TCPC, ABDC, AINV, MRCC, TPVG, TBT.
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 discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.