- This article is the beginning of a series that will walk investors through building a balanced portfolio using BDC stocks, preferred shares, baby bonds and notes.
- BDCs currently have an average annual dividend yield of 12% and are required to invest 70% of assets in U.S. private companies diversified by size and sector.
- BDC stocks are currently pulling back from recent highs and investors should consider their baby bonds and preferreds currently yielding 6.5% to 9%.
- BDCs will begin reporting results next month and investors should be watching closely and ready for a wide range of "winners" and "losers."
- Looking for a portfolio of ideas like this one? Members of Sustainable Dividends get exclusive access to our model portfolio. Get started today »
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. The following slide from ARCC breaks out many of the requirements of the BDC/RIC structure including 70% of assets in U.S. private companies diversified by size and sector.
Source: ARCC Investor Presentation
Most BDCs typically do not directly invest in travel, entertainment, retail, restaurants, sporting event-related, airlines, oil/energy, etc., and if they do it's a small portion of the portfolio. Also, most BDCs have been focused on "investing at the top of the capital structure in businesses with limited commodity and cyclical exposure." The following was provided by ARCC but is similar for most BDCs:
Source: ARCC Investor Presentation
One of the many reasons that I like BDCs is the non-bank structure that allows them to invest at multiple levels of the capital structure. This gives them a wide range of tools during volatile periods such as this so that they can support portfolio companies for the long term while providing significant upside potential for BDC shareholders.
All higher-quality BDCs have credit platforms that have been carefully building their portfolios with a potential recession in mind. However, this pandemic will be a true test of the underwriting skills of management and investors should be prepared for a wide range of "winners" and "losers," much of which already was priced in. BDCs will be reporting Q2 results next month and 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 pressure on net interest margins and dividend coverage.
I have recently added Recession Case (“RC”) pricing to my research taking into account the potential for higher yield expectations driven by many factors including renewed/increased virus-related concerns, a prolonged recession, and/or trade tensions with China.
During the Financial Crisis of 2007-2008, Main Street Capital (MAIN) adequately supported its Lower Middle Market portfolio including additional debt and equity capital as well as assisting management. There were some deferred payments and waived covenants that negatively impacted a couple of quarters, but ultimately MAIN shareholders benefited from realized gains and dividend income from equity investments. MAIN's management was very upfront about the changes in portfolio investments providing shareholders with plenty of information throughout the process.
Over the coming months, I will have a series of articles discussing how to build a retirement portfolio using BDCs currently yielding over 12% and their safer notes, baby bonds/preferred shares with yield-to-maturities ranging from 6.5% to 9.0%.
Please see the previous articles discussing PennantPark Investment (PNNT) currently yielding 12% and its baby bond that trades under the symbol "PNNTG" which was previously trading at a 14% discount to par with a yield-to-maturity of 9.7%.
Also, last week I had an article discussing TriplePoint Venture Growth (TPVG) currently yielding 13%, which provides financing primarily to venture capital-backed technology companies in the U.S. similar to HTGC and HRZN. The article mostly focused on baby bonds with a scatter chart showing various yield-to-maturities including "TPVY" with a yield-to-maturity of 8.4% (for two years).
Investors Need To Be Prepared For Lower Interest Rates
The following chart is from "Visualizing the 700-Year Fall of Interest Rates" showing the historical declines in interest rates:
So Where Can Investors Still Get Higher Yields In This Environment?
- BDCs avoid taxation at the corporate level, allowing them to pass along ordinary income and capital gains directly to the shareholder.
- BDCs are required to distribute ~90% or more of their profits/gains to shareholders providing returns that are significantly different when compared to stocks and bonds.
- 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 (currently over 11%, see list below).
The average annual BDC yield is currently around 12% even after taking into account the dividend reductions most of which were expected especially for FSK, OCSI, MRCC, PNNT, BKCC, TCRD, NMFC, and FDUS. BDCs such as HCAP and CPTA suspended their dividends completely and I was expecting a handful of additional cuts including AINV which is likely already priced in.
As predicted in my April 13, 2020, article "Capitalizing On Recent Lows To Build A Tax-Free BDC Portfolio" BDCs have rebounded for the following reasons:
- They were irrationally oversold
- Continuous stimulus
- Fewer margin calls
- Insider purchases
- Portfolio and capital structure updates by companies
- Investors need adequate portfolio yields (discussed next)
Also, credit spreads have tightened quite a bit over the last two weeks that will drive meaningful increases in net asset value ("NAV") per share but also indicate a potential quicker recovery from the impacts of COVID-19. Is the market correct?
Another important change is the steepening of the yield curve which has a direct impact on the lending sector and likely implies that BDC net interest margins could improve over the coming quarters. Morgan Stanley is betting on a steeper Treasury yield curve, seeing the potential for a “regime shift” in the wake of a rapidly improving U.S. economy.
The table below shows the change in stock price since March 18, 2020, which is just before I made my last major purchases of 14 higher-quality BDCs discussed later. In a follow-up article, I will discuss recent and historical total returns taking into account dividends paid. The average yield on cost for investors who purchased BDCs on March 18, 2020, is around 22.5% (accounting dividend reductions) and hopefully, people are holding these investments in "Tax-Free or Tax-Deferred BDC Accounts" discussed later.
Investing in BDC Baby Bonds and Notes
Many BDCs have investment-grade debt including baby bonds and notes (also known as exchange-traded debt) which are typically for investors who would like to limit the amount of overall risk and pricing volatility in exchange for lower yields. I recently have been suggesting that readers/subscribers invest in these vehicles for a more balanced portfolio as they are currently priced for higher risk-adjusted returns in my opinion. BDCs have permanent equity capital, mostly with 150% or higher asset coverage ratios and over three times cash flow coverage of interest payments.
Source: ARCC Investor Presentation
Worst-case scenarios are mostly related to pain for common shareholders which might have suspended dividends or get diluted by shares issued below book value to strengthen the balance sheet. For these reasons, no BDC has ever defaulted on its borrowings (so far). The following table is from Fidelity Investments showing relative yields for fixed income assets available. Many of the ones offered by BDCs are included, but higher yields are available if you use limit orders that I will discuss in a follow-up article.
It's important to remember that BDCs have what's called permanent equity capital which means that during a worst-case scenario when investors are selling the stock, the company will not be forced to sell assets at a discount. BDCs can simply hold the assets/loans and continue to collect interest and principal payments through maturity with no capital loss to the shareholders as long as there are no credit issues.
Upcoming Articles: In the following article, I will discuss some of the other baby bonds listed above including the ones offered by PSEC, FDUS, MRCC, GLAD, and NEWT. This Sunday, I will have an article discussing FDUS's baby bonds that trade under the symbols “FDUSG,” “FDUSZ” and “FDUSL” that I purchased in March 2020:
Tax-Free or Tax-Deferred BDC Accounts
The dividends paid by BDCs are reported using 1099-DIV and taxed as income and capital gains which is why I suggest holding these investments in tax-free or tax-deferred accounts such as IRAs and 401Ks including Roth accounts as discussed "Capitalizing On Recent Lows To Build A Tax-Free BDC Portfolio."
Please see the previously linked article for a discussion of the following tables showing the compounding of an $85,000 IRA portfolio with $7,000/year contributions and average annual returns of 10% and 15%:
Sources: BDC Buzz and 'math'
Key takeaways are that these investors have (after 20 years):
- $1.0 million to $2.2 million of tax-free savings.
- Earning $100,000 to $300,000 annually tax free for life.
Obviously people have more or less than $85,000 already in retirement accounts, making 10% to 15% annually sounds too good to be true, and 20 years may seem short or long depending on your age. Please do your own calculations.
Clearly for longer-term investors, carefully selected higher yield assets will dominate from a return standpoint but of course, this includes more risk and have an idea who the winners and loser will be. Also, diversification always is key as no one knows for sure what's around the corner.
My Plan for 2020
I was lucky and bought at or very near the recent lows. My average yield on cost for the last 28 purchases was 18.2% and I'm currently collecting dividends, building cash, and waiting for another general market pullback that could be driven by renewed/increased virus-related concerns and/or trade tensions with China.
Over the last three months, BDCs have rebounded and I have recently sold some of my stock positions and will likely be parking the proceeds into safer BDC Baby Bonds and BDC Notes discussed in "Safety BDC Play: Investment-Grade Notes For Ares Capital And Main Street." For now, I'm collecting dividends/distributions:
- Watching for additional announcements
- Gathering information (portfolio and capital structure updates)
- Updating projected changes to NAV and dividend coverage for each BDC
- Waiting for BDCs to report Q2 results next month
- Planning for future purchases.
The information in this article was previously made available to subscribers of Sustainable Dividends, along with:
This article was written by
BDC Buzz is a professional money manager with over a decade of experience generating institutional-quality research.He is the leader of the investing group Sustainable Dividends where he provides investors live portfolios with real-time updates, weekly BDC sector updates, company projection reports, baby bond reports, and live chat access to answer questions. Learn more.
Analyst’s Disclosure: I am/we are long MAIN, ARCC. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.