Gladstone Investment Term Preferred Shares: 7.5% Yield-To-Redemption And Great Safety

Summary

• Gladstone Investment Corporation has two term-preferred stocks with mandatory redemptions in 2023 and 2025.
• GAIN has the best BDC balance sheet in the BDC universe, having no debt whatsoever and extremely low leverage when the preferred stocks are included.
• GAIN management has proven itself to be exceptional.
• Our first choice is the GAIN series E term preferred which sells well below par with a safe 7.5% yield to redemption.
• Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »

Co-produced with Preferred Stock Trader

Gladstone Investment - Excellent Management

Gladstone Investment (NASDAQ:GAIN) is a business development company which primarily makes loans to lower middle market companies. It also has some investments in the preferred stock of these companies. GAIN does have some common equity and warrant positions, but these amount to less than 5% of the company's assets. The company considers itself a "private equity" company.

GAIN is externally managed by Gladstone Management Corporation which has an amazing track record. While many BDCs have had ever-decreasing net asset values (NAVs) over the years, GAIN not only pays out a handsome dividend but owners of GAIN also have been the beneficiary of a stock price that has moved much higher over the years. In fact, over the last 10 years, GAIN's price increase has been higher than the beloved blue chip BDC, MAIN. Here's the 10-year price chart of GAIN.

GAIN 10 Year Price Chart

Source: Etrade

Before the COVID-19 induced bear market, GAIN had seen its stock price triple over the last 10 years, providing investors with a very hefty total return. Even after the large recent sell-off, GAIN has still seen its stock more than double from $5.00 to $10.87 as of the close on April 29. This kind of stock price growth is very impressive for a BDC or for any company that pays out a very high dividend on its common stock.

GAIN Term Preferred Stocks

Term preferred stocks, unlike your typical perpetual preferred stock, actually have a mandatory redemption date, making them somewhat similar to bonds. If GAIN does not redeem their term preferred stock by the redemption date, the dividend will rise by 3%. Readers may have seen this type of "failure to redeem" clause in other preferred stocks, although they are relatively rare. But they are an excellent feature which almost always has resulted in the timely redemption of the preferred stock at par.

As an example, the shipping company Tsakos Energy Navigation (TNP) has a preferred stock with symbol TNP-C which has a failure to redeem clause. Although its yield is much lower than high yielding TNP-E and TNP-F preferred stocks, TNP-C trades at $25.00 while TNP-E and TNP-F trade below $21.00 per share. This "failure to redeem" feature should be a great source of comfort when owning a preferred stock.

Additional features of the GAIN term preferred stocks include the fact that dividends are cumulative, and they are paid monthly. The following are the two GAIN preferred stocks:

1- GAIN 6.25% Cumulative Term Preferred Series D (NASDAQ:GAINM)

• Annual Dividend: $1.5625
• May 1st Price: $23.85
• Call Date: Any time
• Redemption Date: 9/30/2023
• Current Yield: 6.5%
• Yield to Call: Not Applicable
• Yield to Redemption: 7.8%
• Ex-Dividend Dates: Approximately the 18th of each month

2- GAIN 6.375% Cumulative Term Preferred Series E (NASDAQ:GAINL)

• Annual Dividend: $1.59375
• May 1st Price: $23.79
• Call Date: 8/31/2020
• Redemption Date: 8/31/2025
• Current Yield: 6.7%
• Yield to Call: 22.3%
• Yield to Redemption: 7.5%
• Ex-Dividend Dates: Approximately the 18th of each month

Why We Currently Have A Preference For GAINL

1) GAINL has a higher "yield to redemption"

2) We like that the GAINL redemption date is further out as we hope that we can hold it for as long as possible. There just aren't preferred stocks out there with this level of safety and yield.

3) Although it's certainly unlikely that GAINL will be called at its first opportunity, the yield to call is a very high 22%. If things settle down with the markets, and interest rates remain very low (as we expect), a call is possible on GAINL much prior to its redemption date which would provide a total return that could be significantly higher than its 7.5% yield to redemption. A call on GAINL one year from today would provide GAINL investors a 12% total return. Given that GAINL has more upside on a call (and in general) than GAINM, we prefer GAINL.

Safety

Balance Sheet Safety

Source: GAIN 10-Q Feb. 2020

As can be seen, GAIN has total assets of $583 million with total liabilities of only $172 million. This works out to liabilities being less than 30% of assets. GAIN is a company with extraordinarily low leverage and high safety. Even blue chip BDC Main Street Capital (MAIN), with its excellent balance sheet, has higher leverage at 43% liabilities to assets. While the law has changed, allowing BDCs to lever up to 67%, GAIN has not followed a number of BDCs in leveraging up its balance sheet. In fact, GAIN's leverage has dropped 6% from a year ago. GAIN's aversion to debt is something that makes their preferred stocks really special.

Zero Debt

And speaking of aversion to debt, you will notice that GAIN has zero debt. Therefore, a GAIN bankruptcy is almost impossible. Their liabilities are primarily their term preferred stocks - GAINL and GAINM. This means in a liquidation, term preferred holders have no debtholders ahead of them in line to capture the value of assets. The fact that these preferred stocks are at the top of the capital stack of a company with very low leverage makes GAINL and GAINM much safer than virtually all BDC baby bonds. Besides having much higher leverage than GAIN, many BDC baby bonds have secured debt ahead of them in the capital stack making them riskier than GAIN's preferred stocks. GAIN is actually using a financing model that's similar to Public Storage (PSA) and PS Business Parks (PSB) which operate with very low leverage and little to no debt while using preferred stock to raise capital, with the important distinction that PSA and PSB's preferred stocks do not have mandatory redemptions like the GAIN preferred stocks which just adds to their attraction.

Legal Leverage Limits On BDCs Make Their Fixed-Income Securities Extremely Safe

Baby bonds and term preferred securities have an excellent track record for safety. In fact, we are not aware of a single BDC preferred stock or baby bond that has missed an interest/dividend payment. Because of the legal leverage limits on BDCs, if the assets of a BDC deteriorate in value to the point where the BDC is up against its leverage limit, it must take actions to deleverage. Thus, it's very difficult for a BDC to get into trouble in terms of its solvency.

GAIN Common Stock Dividend

While many BDCs are expected to cut or suspend their common dividends, GAIN already has reported that their common dividend will remain unchanged, so GAIN management is confident in its future.

Safe From COVID-19 and Energy Risk

According to management, GAIN focuses on lending and investing in companies with sustainable market positions and cash flows. In terms of companies in their portfolio which have significant risk in the current environment, we found no retailers, restaurants, hotels, entertainment/leisure companies nor any travel related companies in their portfolio. In terms of energy, their investment in the energy sector is less than 1% of assets.

GAIN's Conservative Investment Criteria

Source: Gladstone Investment Corp.

Highly Unusual Opportunity - GAINL's Yield-to-Redemption Almost Equal To GAIN's Common Stock Yield

Currently, GAINL's yield-to-redemption is 7.5% while the yield on GAIN common stock is 7.9%. In stable market environments, it's highly unusual to be able to buy a BDC term preferred or baby bond with a yield near that of the common stock - especially given the much increased safety of the baby bonds and term-preferred stocks versus the common stock. Normally, baby bond and term preferred yields are much lower than the common stock yield. This presents what we believe is quite a good entry point for GAINL and GAINM.

Example Of How GAIN Term Preferreds Are Grossly Underpriced

Granted, this is not exactly apples to apples comparisons, but we think the following comparison gives an idea of the undervaluation of GAIN's term preferred stocks.

Comparison to BDC Ares Capital (ARCC)

• Yield to maturity of ARCC's 2025 bond is 5.6% versus a 7.5% yield to redemption for GAINL (also a 2025 redemption).
• ARCC common shares have a lower price than they did 10 years ago, while GAIN's common shares have more than doubled in price.
• ARCC has a large revolving credit facility ahead of its 2025 bond in its capital stack versus GAINL being at the top of GAIN's capital stack.
• GAIN is leveraged at 30%, while ARCC carries 50% leverage.

So, to us, the yield on GAINL is much higher than it should be relative to ARCC's 2025 bond, as GAIN actually has lower leverage and a better track record than ARCC.

Fair Value

We see no reason why both GAINL and GAINM shouldn't again trade over $25.00. In the current near-zero interest rate environment, once the market settles down, we think that investors will flock to safe fixed-income investments. That has been the pattern after every fixed-income sell-off. We believe safety will be of utmost importance to investors going forward, and GAIN is one of the safest BDCs and GAINL and GAINM are about as safe a fixed-income investment in the BDC sphere as you will find. We believe that both are buys - GAINL below $24.50 and GAINM under $24.30. The mandatory redemption feature of GAIN preferred stocks provides a high degree of certainty that the price of both GAINL and GAINM will rise over time from current levels.

Summary

We believe that term preferred stocks GAINL and GAINM are currently strong buys, with GAINL being a very strong buy at current prices with a 7.5% yield to redemption and potential for an even higher total return should GAINL be called earlier than its redemption date (12% return if GAINL is called in one year). GAIN management has proven itself exceptional as GAIN has greatly outperformed the typical BDC and has done so using unusually low leverage.

We love the safety of the GAIN term preferred stocks. GAIN has zero debt, an extremely safe balance sheet (very low leverage), great management, and GAIN has virtually no investments in energy or sectors that are hit hard by COVID-19 such as retail, travel, leisure, etc. GAIN recently reported that their common dividend will not be cut showing great confidence in the company going forward despite tough economic times.

We believe we have an excellent buying opportunity at current prices as the GAIN term preferred stocks are well below their highs and have yields-to-redemption that are almost equal to GAIN's common stock yield - a highly unusual situation in the BDC world where term preferred stocks and baby bonds virtually always carry significantly lower yields than their common stocks.

Thanks for reading! If you liked this article, please scroll up and click "Follow" next to my name to receive our future updates.

Analyst’s Disclosure: I am/we are long GAINL. 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.