Over the coming weeks, I will have a series of articles discussing how to build a retirement portfolio using Business Development Companies ("BDCs") currently yielding over 10% and their safer baby bonds/preferred shares currently yielding over 6%.
Specifically, this article discusses:
- Monroe Capital (MRCC) - 14% yield
- Owl Rock Capital Corporation (ORCC) - 9% yield with specials
- TPG Specialty Lending (TSLX) - 9% yield with specials
As mentioned in "Building A Retirement Portfolio With BDCs Currently Yielding 10.6%", interest rates will likely remain low and investors will continue to need equity investments (stocks) to generate an adequate portfolio yield. BDCs pay higher-than-average yields with the average BDC currently yielding over 10%. Safer BDCs are closer to 9% annual yield but patient investors can get higher yields by taking advantage of volatility. For discussion of portfolio allocations, please see the previously linked article.
What is a BDC?
Business Development Companies ("BDCs") were created by Congress in 1980 to give investors an opportunity to invest in private small and mid-sized U.S. companies typically overlooked by banks. Most BDCs are publicly traded with a highly transparent structure subject to oversight by the SEC, states and other regulators, providing investors with higher than average dividend yields (most between 7% and 14% annually, see details below) by avoiding taxation at the corporate level. This allows them to pass along ordinary income and capital gains directly to the shareholder.
Please see "High-Yield BDC Sector Continues To Outperform The S&P 500 In 2019" for recent total returns by BDC including MRCC and TSLX that are currently beating the S&P 500. ORCC became public earlier this year and is discussed later.
Assessing Risk for BDCs
As mentioned in "Assessing Risk: Retirement Portfolio Using BDCs", assessing risk is critical when investing and pricing BDC stocks. I assign a risk rank for each company that focuses on capital preservation including net asset value ("NAV") per share stability as well as portfolio strength to sustain dividend payments. This includes the ability of the portfolio to retain value during an economic downturn. One of the best approaches to assessing risk in a BDC portfolio is using a "vintage analysis" that takes into account many aspects including the time frame that each loan was originated as well as asset class, maturity, directly originated vs. syndicated, industry sector, PIK, and cash yields.
Not All First-Lien is Equal
The most common mistake that new BDC investors make is comparing them to closed-end funds ("CEFs") or other non-actively managed funds, believing that trading at a large discount to NAV/book value is a good thing.
Buying a BDC is like buying a car and there are typically very good reasons for the wide range of dividend yields and price-to-book values. I see plenty of articles pushing risky BDCs that are trading at a large discount to book value as if they found a deal that no one knows about.
BDCs such as MCC and FSC (now OCSL) grew their portfolios at potentially riskier lending periods and are examples that not all BDCs with large amounts of first-lien debt are necessarily 'safer' than others. Before the recent credit issues, MCC had a portfolio of almost 70% senior secured first-lien debt, that is still almost 50%, but over the last 5 years, declining credit quality has resulted in five dividend cuts (its dividend is currently suspended) and over 64% decline in NAV per share as shown below.
MCC traded at a price of over $5.00 early last year but was a 40% discount to its 9/30/17 NAV per share of $8.45. The company reported its 12/31/17 results on 2/6/18 and the stock quickly fell below $5.00 and as of 6/30/19, its NAV per share is $4.55. My point is - there is a reason why it still trades at a 45% discount to NAV and no it's not a good deal even at these prices.
Sources: SEC Filings & BDC Buzz
BDC Portfolio Vintage Analysis
One of the best approaches to assessing risk in a BDC portfolio is using a "vintage analysis" that takes into account many things including the time frame that each loan was originated as well as asset class, maturity, directly originated vs. syndicated, industry sector, PIK, and cash yields. BDCs that were lending during times of less protective covenants and higher leverage multiples while maintaining higher-than-average yields, will likely have upcoming credit issues regardless of the overall economy as we have seen with MCC, FSK, FSC (now OCSL), PTMN, CPTA, BKCC, TCAP (now BBDC), GARS, and TCRD. Many of the other BDCs that I have considered 'higher risk' are already experiencing credit issues and will likely get worse over the coming quarters.
- Please see the previously linked "Assessing Risk" article for a detailed discussion of assessing portfolio risk.
After going through this analysis each quarter, there is a clear trend with riskier vintages and ongoing or upcoming credit issues that I include in the 'Watch List" for each BDC and will discuss for ORCC, MRCC, and TSLX next.
ORCC Risk Profile "Quick Update"
Article Follow-Up: I started a position in Owl Rock Capital Corporation on its IPO debut at a price of $15.35 for the reasons discussed in "Hot IPO: Owl Rock Capital Yielding 9% To 10% Out Today". ORCC is currently trading $16.16 and I have earned $0.33 in dividends for a total return of 7% over the last 82 days.
As of June 30, 2019, based on fair value, ORCC's portfolio consisted of 81% first lien senior secured debt investments, 17% second lien senior secured debt investments, 1% investment funds and vehicles, and 1% in unsecured debt investments and equity investments.
Source: ORCC Company Presentation
There were no investments on non-accrual status with only minor markdowns in some of its 'watch list' investments including Feradyne Outdoors, Give and Go Prepared Foods and Accela, Inc. that need to be watched. However, these investments account for less than 3% of the total portfolio:
Sources: SEC Filings & BDC Buzz
MRCC Risk Profile "Quick Update"
Upcoming Article: Later this week, I will have a more in-depth article discussing Monroe Capital.
As mentioned in many articles, MRCC was previously downgraded due to continued credit issues including adding Education Corporation of America ("ECA") to non-accrual status, previous markdowns of Rockdale Blackhawk and realized losses from TPP Operating, Inc. During Q2 2019, its NAV decreased by $0.15 or 1.2% (from $12.67 to $12.52) mostly due to additional markdowns in previously discussed investments including American Community Homes, Inc. ("ACH") as well as its retail-related investment in The Worth Collection, Ltd.
My primary concern is the potential for additional non-accruals and markdowns of the investments listed in the previous table that currently account for around 15% of the portfolio and 36% of NAV per share. My worst-case projections take into account additional credit issues that could result in a dividend reduction of around 25% that I will discuss in an upcoming article.
TSLX Risk Profile "Quick Update"
Upcoming Article: Later this month, I will have a more in-depth article discussing TPG Specialty Lending including excellent underwriting standards that protect shareholders during worst-case scenarios including voting control, call protection prepayment fees and amendment fees backed by first-lien collateral of the assets.
As of June 30, 2019, 100% of TSLX's portfolio was meeting all payment and covenant requirements. First-lien debt remains around 97% of the portfolio and management has previously given guidance that the portfolio mix will change over the coming quarters with "junior capital" exposure growing to 5% to 7%.
Source: SEC Filing
Source: TSLX Company Presentation
During Q2 2019, TSLX's net asset value ("NAV") per share increased by $0.34 or 2.1% (from $16.34 to $16.68) due to overearning the dividends by $0.07 per share after excluding excise tax, unrealized gains on its interest rate swaps of $0.09 per share and $0.19 per share of changes in portfolio valuations including Validity, Inc. discussed earlier and Ferrellgas Partners, L.P. (FGP) together accounting for around $0.17 per share of unrealized gains:
There were some additional markdowns in the three 'watch list' investments Mississippi Resources, Vertellus Specialties, and IRGSE Holding Corp. but mostly related to the equity positions as shown in the following table. However, its first-lien position in Mississippi Resources was marked down to 92% of cost and needs to be watched:
It is important for investors to understand that one of TSLX's strategies for higher IRRs is investing in distressed retail asset-based lending ("ABL") as "traditional brick and mortar retail gives way to the rise of e-commerce". Historically, borrowers have paid amendment fees to avoid even higher prepayment fees if they decided to refinance. Also, the amendments included an additional "borrowing base" providing increased downside protection on the investment. This strategy continues to drive higher fee income including prepayment and amendments fees and will discuss in an article later this month.
Q3 2019 BDC Reporting Schedule
As BDCs start to report results later this month (including ORCC, see schedule below), investors should be watching for potential portfolio credit issues that could lead to credit rating downgrades. Lower ratings would likely drive higher borrowing expenses that could put downward pressure on net interest margins and dividend coverage over the coming quarters.
General BDC Recommendations
Safer BDCs are averaging around 9.0% yield compared to the average which is closer to 10.3% as shown in the first table, but patient investors can get higher yields by taking advantage of volatility. Over the years, I have carefully built a portfolio that I continually adjust. I made 28 purchases of safer BDCs throughout 2018 with an average yield on cost of 10.5% and currently averaging over 20% annualized returns. For investors that are looking to build a BDC portfolio, please consider the following suggestions:
- Identify BDCs that fit your risk profile.
- Set appropriate price targets for limit orders to make purchases during trading volatility.
- Dipping your toe in: it is important for new investors to be patient and start with a small amount of shares using limit orders. Initiating a position will likely help with gaining interest and following the stock (and management team) to develop a comfort level for future purchases.
- Opportunity cost: keep in mind that while you are waiting for lower prices, BDCs are paying dividends.
- Dollar averaging purchases: there will be a general market and/or sector volatility driving lower prices providing opportunities to lower your average purchase prices.
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Disclosure: I am/we are long ORCC, TSLX. 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.