Will 6.125% From GLAD Make You Happy?

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About: Gladstone Capital (GLAD), Includes: GAIN, GAINL, GLADN, HTGC, OFS
by: Rubicon Associates

Summary

Gladstone Capital has issued 6.125% senior unsecured baby bonds ($25 par).

The new issue provides investors with a lower duration and senior status for a better yield than its outstanding preferred.

My thoughts on the new issue.

Given the recent rise in interest rates, and the risk environment generally, there has not been many preferred stocks or baby bonds issued. This has changed over the last week with a new $25 par unsecured bond ("baby bond") from Gladstone Capital Corp. (NASDAQ:GLAD).

Business Description

Gladstone Capital Corp. is a business development corp which focuses on investing in lower middle market companies (generally defined as companies with EBITDA of $3 million to $15 million). GLAD lends to borrowers that need funds for growth capital or to finance acquisitions or recapitalize or refinance their existing debt facilities. Targeted portfolio companies are generally considered too small for the larger capital marketplace. In general, investments in debt securities have a term of no more than seven years, accrue interest at variable rates (based on the one-month LIBOR) and, to a lesser extent, at fixed rates.

As of June 30, 2018, GLAD's investment portfolio consisted of investments in 50 portfolio companies located in 25 states in 18 different industries, with an aggregate fair value of $404.9 million.

An overview of their portfolio shows that the company has been diversifying their investments through growth (lower exposure to the top five, despite increased investment size) and focusing on quality investments (as reflected through the much lower non-performing portion of the portfolio - admittedly, during the "good times").

Source: company presentation.

The details of the offering are:

Source: Offering documents, author compiled.

Covenants:

  • As long as the notes are outstanding, the company will not violate Section 18(A)(1)(A) as modified by such provisions of Section 61(A) of the 1940 Act (as may be applicable to us from time to time or any successor provisions, whether or not we continue to be subject to such provisions of the 1940 Act). Currently, these provisions generally prohibit the company from incurring additional debt or issuing additional debt or preferred securities, unless their asset coverage equals at least 200% (or 150% on and after April 10, 2019) after such incurrence or issuance.
  • GLAD agrees that while the notes are outstanding, they will not declare any dividend (except a dividend payable in stock of the issuer), or declare any other distribution, upon a class of our capital stock, or purchase any such capital stock, unless, in every such case, at the time of the declaration of any such dividend or distribution, or at the time of any such purchase, we have an asset coverage (as defined in the 1940 Act) of at least the threshold specified under Section 18(A)(1)(B) as modified by such provisions of Section 61(A) of the 1940 Act

Event of Default:

  • They do not pay of principal of any Note when due and payable at maturity,
  • They do not pay interest on any Note when due and payable, and such default is not cured within 30 days of its due date,
  • They remain in breach of any other covenant in respect of the Notes for 60 days after they receive a written notice of default stating they are in breach (the notice must be sent by either the trustee or holders of at least 25% of the principal amount of the outstanding Notes),
  • They file for bankruptcy or certain other events of bankruptcy, insolvency or reorganization occur and remain undischarged or unstayed for a period of 60 days, or
  • On the last business day of each of twenty-four consecutive calendar months, the Notes have an asset coverage of less than 100%.

Gladstone Outstanding Issues

Gladstone Capital, and the various Gladstone managed businesses, have the following preferred stock outstanding:

Source: Author spreadsheets.

The following is the pricing data of the various Gladstone managed businesses:

Source: Author spreadsheets.

A higher yield on senior unsecured relative to GLAD's preferred asks for a swap to be done - picking up seniority and yield for longer call protection but shorter maturity (duration risk). The yield is comparable (albeit slightly lower) to the recently issued Gladstone Investment (GAIN) Series E preferred (GAINL) - where it has seniority and a similar maturity date.

Source: Author spreadsheets.

Yield-to-call, graphically:

Source: Author spreadsheets.

The following chart shows the preferred yield relationship of the Gladstone entities, where GLAD typically resided at the lowest yields of the bunch (while exhibiting more yield volatility than the rest as well):

Source: Author spreadsheets.

Peer Comparison And Relative Value

The following table contains the market data for GLAD peers, including OFS Capital (OFS) and Hercules Capital (HTGC):

Source: Author spreadsheets.

As the table shows, the Gladstone issues have lower yields than many of their peers. This is, in part, due to their reputation and their conservative financial metrics:

Source: Author spreadsheets.

Preferred peer group stripped yield, graphically:

Source: Author spreadsheets.

Preferred peer group yield-to-call, graphically:

Source: Author spreadsheets.

The yield on a preferred stock versus a common stock is often a function of volatility and dividend consistency. If a common stock's dividend has a history of changes, or has the potential to get cut going forward, the consistency of the preferred is valued and the yield will often be less than that of the preferred.

Equity REIT preferred has a higher yield than the common (on average due to lack of growth potential), mREIT preferred has a lower yield than the common (on average due to greater stability), banking/financial preferred has a higher yield than the common (on average due to lack of growth potential), and BDC preferred typically has a lower yield than the common as a result of lower volatility and exposure to the vicissitudes of leveraged lending to smaller companies.

Source: Author spreadsheets.

The equity/preferred yield spread expressed graphically:

Source: Author spreadsheets.

As the following chart shows, the spread between Gladstone equity and preferred (NASDAQ:GLADN):

Source: Author spreadsheets.

As well, it is helpful to look at the spread to risk-free, as this is the risk premium assigned to each instrument and issuer. Gladstone Capital has the lowest risk premium of the peer group.

Source: Author spreadsheets.

The spread to risk-free, graphically:

Source: Author spreadsheets.

The following chart shows the Gladstone preferred's spread to risk-free. Due to a sell-off in GLADN, its spread is now comparable to Gladstone Investment (NASDAQ:GAINM).

Source: Author spreadsheets.

Equity Perspective

Gladstone companies have underperformed similar benchmarks.

Chart GLAD data by YCharts

Bottom Line: While there are higher-yielding preferred stocks available to investors in the BDC space as well as other spaces (REIT, financial and shipping), I like the senior unsecured nature and near(er)-term maturity date of this security, which should serve to dampen volatility. Owners of GLADN should consider swapping into GLADD as a means of moving up the priority ladder for a similar maturity date, extended optional redemption date and comparable yield.

Disclosure - Long GAINL, GOODM and NEWT in accounts I control.

Helpful Links:

GLAD Indenture

GLAD Supplemental Indenture (Nov 6, 2018)

GLAD 6.125% '23 Prospectus

Most recent 10-Q

Disclosure: I am/we are long GAINL, GOODM, NEWT.

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.