8% To 10% Balanced Portfolio Yield Investing In America: Part 2
Summary
- This is a series of articles discussing retirement portfolios using BDCs currently yielding more than 12% and their safer notes, baby bonds/preferred shares with yield-to-maturities ranging from 6% to 9%.
- This article discusses the interest expense and asset coverage ratios for one of the higher-yield BDCs (~13.5%) and its three Baby Bonds that I own.
- This information is used along with portfolio credit quality to rank each Baby Bond as "Lower Risk," "Average Risk," or "Higher Risk."
- Then I use the BDC Google Sheets to track real-time pricing, accrued interest, effective yields, yield-to-call, and yield-to-maturity to assess which ones are "Buys," "Holds" and "Sells."
- 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 »
Introduction:
Over the coming months, I will have a series of articles discussing how to build a retirement portfolio using Business Development Companies ("BDCs") currently yielding over 12% and their safer notes - baby bonds/preferred shares with yield-to-maturities ranging from 6.5% to 9.0%.
This article discusses Fidus Investment (FDUS) currently yielding 13.5% and its Baby Bonds that trade under the symbols “FDUSG”, “FDUSZ” and “FDUSL" currently with yield-to-maturities between 8% and 9%.
Business Development Companies 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 Ares Capital (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.
Most BDCs typically do not directly invest in travel, entertainment, retail, restaurants, sporting event-related businesses, airlines, oil/energy, etc., and if they do it's a small portion of the portfolio. FDUS has 62 portfolio companies across 22 industry segments that include healthcare, aerospace, oil and gas, and retail, which are mostly second-lien and subordinated loans which is one of the reasons that I do not own common shares but I do own the Baby Bonds discussed next.
Source: FDUS Investor Presentation
First-lien debt has increased as a percentage of the overall portfolio from 8% to 19% over the last five quarters but is still much lower than most BDCs.
Source: SEC Filings
As of March 31, 2020, non-accruals account for around 6.7% of the portfolio fair value and 8.6% at cost:
The facts and circumstances were different in all three scenarios. One company was late paying us and the other was not fully operational due to shelter in place orders. They both did pay us our quarterly interest so those are the full non-accruals. And what's similar is that shelter in place directives meaningfully impacted both companies. One of those is EbLens, it's a retailer in the northeast and the second was Virginia Tile that has some operations in Michigan and they obviously were meaningfully impacted as well due to SIP orders there. Our PIK non-accrual Mirage also experienced shelter in place orders, but actually was later designated an essential business. So that's how that unfolded. Hopefully, that's helpful. But they are more proactive - they all did pay us what they were supposed to, but we did put them on non-accrual due to risk points.”
Source: FDUS Earnings Call
Source: SEC Filings
Accent Food Services remains on non-accrual and was discussed on the recent call:
Q. “Moving on to Access Foods. So kind of just from a lon-term outlook perspective. Given their focus on, as I understand it, breakroom solutions and things like that. Even with people returning to work, it seems like the breakroom operations and things like that are definitely going to be a while off and returning to normal. So any color you can give on long term outlook for that asset?
A. “Long-term outlook is a very difficult thing to answer, with regard to any credit from my perspective at this point. So I didn’t see any creditors, we actually have over 80% of our portfolio that we think is in very sound shape, doesn't mean perfect but sound and well over 80. But what I would say with regard to the accident is that management is doing a great job of kind of managing the situation that they're facing, which is this company was impacted as you might imagine or I'm sure understand by the shelter in place orders. And so they have done a very good job of managing thus far through the situation. How the company comes out of it, how we navigate the situation, there's a lot of uncertainty with that and it's very difficult to handicap. So I'm not going to try to for that reason.
Source: FDUS Earnings Call
FDUS Management Fee Agreement:
FDUS has a base management fee of 1.75% of assets excluding cash and does not include a “total return hurdle” or “lookback” feature when calculating income incentive fees. However, the capital gains incentive fees have a lookback feature measuring cumulative aggregate realized capital gains and losses since the “Formation Transactions” and IPO.
Management is focused on capital preservation and closely tracks relevant credit metrics such as debt-to-EBITDA and cash interest coverage ratios of portfolio companies. This focus is partially responsible for the above-average NAV per share growth.
My primary concerns for FDUS are mostly related to almost 30% of the portfolio invested in equity and subordinated debt positions that include many higher-risk sectors as well as the 6.7% of the portfolio already on non-accrual as of March 31, 2020. This combined the lack of total return hurdle incentive fee structure to protect shareholders from capital losses that could result in material losses for common shareholders. Again, this is another reason that I do not own the common stock.
FDUS's Baby Bonds “FDUSG”, “FDUSZ” and “FDUSL”:
On Oct. 16, 2019, FDUS announced the closing of its $55 million of its 5.375% notes due 2024 under the trading symbol “FDUSG” “within 30 days of Oct. 16, 2019” which is included in the BDC Google Sheets along with “FDUSZ” and “FDUSL.” Please see the table at the end of this article with the updated yields for each compared to the others.
Source: Quantumonline
Interest Expense and Asset Coverage Ratios
The interest coverage ratio is used to see how well a firm can pay the interest on outstanding debt. Also called the times-interest-earned ratio, this ratio is used by creditors and prospective lenders to assess the risk of lending capital to a firm. A higher coverage ratio is better, although the ideal ratio may vary by industry. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.
The asset coverage ratio is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets. The higher the asset coverage ratio, the more times a company can cover its debt. Therefore, a company with a high asset coverage ratio is considered to be less risky than a company with a low asset coverage ratio.
Please see the following links from Investopedia for more information:
I continue to track both of these measures (along with many others) for all BDCs historically and using financial projections through 2020. This information is used along with portfolio credit quality to rank each Baby Bond as "Lower Risk," "Average Risk," or "Higher Risk." Then I use the BDC Google Sheets to track real-time pricing, accrued interest, effective yields, yield-to-call, and yield-to-maturity to assess which ones are "Buys," "Holds" and "Sells." The Sell indicator is only used when the pricing is at a certain amount above par and there is the possibility of being called that could result in capital losses. As shown in the previous table, there are very few Baby Bonds with effective prices above par ($25). This will be covered in-depth in upcoming articles.
Some of the options that BDC management teams have before potentially defaulting on a debt obligation including:
- Reducing the dividend to common shareholders
- Reducing or waiving management and incentive fees
- Raising equity capital: Common or preferred even dilutive to common if needed
- Raising debt capital (likely unsecured at a higher cost)
- External manager/credit platform can provide additional capital if needed
- Selling assets
For these reasons, no BDC has ever defaulted on a debt obligation (at least so far, Medley Capital (MCC) might be the first).
The following table shows the historical coverage information for FDUS:
Trading Volumes and Recent Price History
One of the issues with Baby Bonds is that they do not currently have adequate trading volumes for larger investors but hopefully these articles will help with that over the coming weeks. Larger investors typically trade the BDC Notes discussed in "Safety BDC Play: Investment-Grade Notes For Ares Capital And Main Street" and I will cover again in upcoming articles.
Source: Yahoo Finance
The following image is from Fidelity Investments. Please use limit orders! Also, the yield quoted is the effective yield which is lower than the yield-to-maturity due to trading below par.
Source: Fidelity
As shown below, FDUSG, FDUSZ, and FDUSL were trading around $25.00/$26.00 earlier this year and then dipped in March 2020 along with the general markets. I was actively purchasing stocks and bonds during this period, including these three.
Source: Fidelity
As shown in the table below from BDC Google Sheets, there's a wide range of yields currently being offered. I believe that this a very attractive investment given investors can simply hold over the next two to five years and collect the quarterly distributions before being redeemed at par of $25.
Source: BDC Google Sheets
Upcoming Articles/Blogs:
I will likely be using the Blog feature (as compared to public articles) on SA as well as my own site for additional updates on individual BDCs. The following BDCs have tradable Notes, Baby Bonds & Preferreds that I will discuss in upcoming articles along with relative risk: ARCC, CPTA, CSWC, FDUS, FSK, GAIN, GECC, GLAD, GSBD, HTGC, MAIN, MCC, NEWT, NMFC, ORCC, PNNT, PSEC, TCPC, TCRD, TPVG, and TSLX.
Please read the introduction to "8% To 10% Balanced Portfolio Yield Investing In America" that discusses using Tax-Free or Tax-Deferred BDC Accounts as well as general information about BDCs and their Baby Bonds.
The information in this article was previously made available to subscribers of Sustainable Dividends, along with:
- Real-time changes to my personal BDC positions
- Target prices and buying points for each BDC
- Real-time announcement of changes to dividend coverage and worst-case scenarios
- Updated rankings and risk profiles
- Preview of upcoming public articles
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 FDUSG, FDUSZ, FDUSL. 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.
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Comments (47)
But Main stopped paying supplemental dividend paid in June and December this year but is it correct to call a cut?
IT....