High-Yield ETFs Vs. Higher Yield BDCs: Yield Spreads

| About: iShares iBoxx (HYG)
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Summary

HYG and JNK have historically had closer yields to BDCs and could be relatively overpriced.

BDCs have been easily outperforming HYG and JNK and still pay much higher dividend yields.

The average BDC currently has a dividend yield of 9.4% and will likely continue to outperform HYG and JNK.

As mentioned in "High-Yield Bond ETFs Are Getting Crushed by BDCs," business development companies ("BDCs") continue to outperform high-yield corporate bond ETFs such as the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) and the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK). The following charts shows the stock performance for HYG and JNK compared to the UBS ETRACS Wells Fargo Business Development Company ETN (NYSEARCA:BDCS) and the S&P 500.

Please keep in mind that this does not take into account distributions paid.

Will BDCs continue to outperform HYG and JNK?

As mentioned in "Yield-Based Pricing For The BDC Sector,"

"I also take into account the yield spreads between BDCs and other investments including corporate public debt ratings B and CCC or below (discussed in Part 4). Yield spreads are important to monitor as they can indicate when a basket of investments is overbought or oversold relative to other yield-related investments. However, it is also important to point that these spreads change over time depending on perceptions of risk and that these are only averages that then need to be assigned a range for assessing individual investments/BDCs."

The following chart shows the change in yield spreads between the average BDC compared to HYG and JNK. As BDC yield spreads become wider, I generally consider them to be oversold which is when I make larger purchases as discussed in "BDC Buzz Begins 2016 Purchases" and "Are BDCs at Another Buying Point" and shown in the chart below.

As mentioned earlier, yield spreads change over time depending on perceptions of risk. Currently, the market is in a "risk on" mode and BDCs will likely continue to set new 52-week highs as discussed earlier this month in "New 52-Week Highs For The BDC Sector."

Another good article discussing reasons not to invest in HYG and JNK is "The ETF Illusion: An Inside Look" by fellow contributor The Heisenberg.

BDCs are still offering higher yields:

Even though BDC stock prices have recently appreciated more than most higher yield investments, they still offer much higher dividend yields. The average BDC dividend yield is currently around 9.4%, which is higher than the ETN BDCS (with 7.5%) due to fees and BDC allocations.

However, as discussed in "Assessing Dividend Coverage For BDCs," it is important for BDC investors to assess the sustainability of dividends, which includes:

  • Historical dividend coverage: Using adjusted earnings (excludes certain one-time expenses) taking into account recurring vs. one-time revenues, cash vs. PIK interest income, etc.
  • Projected dividend coverage: Using best, base and worst-case scenarios taking into account potential credit issues, portfolio growth/decline, changes to portfolio yield, various amounts of non-recurring income from dividends and fees, changes to borrowing and operational expenses.
  • Optimal Leverage Analysis: Assessing future dividend coverage based on portfolio growth using available cash and borrowings (leverage) as well as changes in portfolio yield, apples-to-apples comparison of BDC dividend coverage using similar amounts of leverage.

For previous articles on each of these dividend coverage drivers as well as BDC pricing and rankings, suggested BDC portfolios, dividend coverage tiers, pricing charts, interest rate discussion, my upcoming/historical purchases and current positions, please see "Index of BDC Articles by Topic."

Typically, the higher yield BDCs such as TICC Capital (NASDAQ:TICC), KCAP Financial (NASDAQ:KCAP), Medley Capital (NYSE:MCC), Capitala Finance (NASDAQ:CPTA), THL Credit (NASDAQ:TCRD), Garrison Capital (NASDAQ:GARS), WhiteHorse Finance (NASDAQ:WHF), TriplePoint Venture Growth (NYSE:TPVG), BlackRock Capital Investment (NASDAQ:BKCC), Horizon Technology Finance (NASDAQ:HRZN), Fifth Street Finance (NYSE:FSC), Prospect Capital(NASDAQ:PSEC), and Newtek Business Services (NASDAQ:NEWT), in the table above are likely "perceived" to have potential issues related to capital preservation (risk) and/or dividend coverage from stable sources. I am currently anticipating 2 to 3 of these BDCs cutting dividends in the coming quarters.

Fifth Street Senior Floating Rate (NASDAQ:FSFR), Apollo Investment (NASDAQ:AINV), PennantPark Investment (NASDAQ:PNNT), and Triangle Capital (NYSE:TCAP), were previously included in the higher-than-average yield group before cutting their dividends. Please see previous "Dividend Analysis" articles for more.

BDCs with higher credit quality portfolios and/or higher quality management that typically "does the right thing" for shareholders, usually have lower dividend yields. I currently believe that there are quite a few BDCs mispriced but currently the lower-yielding BDCs are Golub Capital BDC (NASDAQ:GBDC), FS Investment Corp. (NYSE:FSIC), Solar Capital (NASDAQ:SLRC), Main Street Capital (NYSE:MAIN), Goldman Sachs BDC (NYSE:GSBD), Ares Capital (NASDAQ:ARCC), Gladstone Investment (NASDAQ:GAIN), PennantPark Floating Rate Capital (NASDAQ:PFLT), TCP Capital(NASDAQ:TCPC), TPG Specialty Lending (NYSE:TSLX), Solar Senior Capital (NASDAQ:SUNS), Hercules Capital (NASDAQ:HTGC), Saratoga Investment (NYSE:SAR) and Monroe Capital (NASDAQ:MRCC).

To be a successful BDC investor:

  • Identify BDCs that fit your risk profile (there are over 50 publicly traded BDCs, please be selective).
  • Diversify your BDC portfolio with at least 5 companies.
  • Establish appropriate price targets based on relative risk and returns (mostly from dividends).
  • Be ready to make purchases during market volatility and look for opportunistic buying points.
  • Closely monitor your BDCs, including dividend coverage potential and portfolio credit quality.

Personal note: I have updated my positions to reflect changes in my holdings, but please keep in mind that some of the positions are very small and mostly for research purposes. There are over 50 publicly-traded BDCs, and I try to cover as many as possible, but I do not have the bandwidth to include each company for each article.

Disclosure: I am/we are long ABDC, ACSF, AINV, ARCC, BKCC, FDUS, FSC, FSFR, FSIC, GAIN, GARS, GBDC, GLAD, GSBD, HCAP, HTGC, MAIN, MCC, MRCC, MVC, NMFC, PFLT, PNNT, PSEC, SAR, SCM, SLRC, SUNS, SVVC, TCAP, TCPC, TPVG, TSLX, WHF.

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.