War, Inflation, Rising Interest Rates? No Time To Be A Hero; Check Out Barings BDC

May 06, 2022 11:55 PM ETBarings BDC Inc (BBDC)MCI, MCO, MPV, PRU56 Comments45 Likes

Summary

  • Nervous about what's going on in the markets, the economy and the world in general? So am I.
  • As an investor I don't want to be a hero, especially in the current environment, but I can't afford to move to the sidelines and give up income.
  • I want a rock-solid business, experienced management, able to "muddle through" whatever challenges we face in the next few years, especially inflation and higher interest rates.
  • Like Barings BDC: priced at a 15% discount to its net asset value and yielding 9.5%, with secured, floating-rate loan assets to help us withstand inflation and rising rates.
  • What's not to like? Apparently not much, judging by all of the top institutional investors who agree, and are right in there investing along side of us.
  • Looking for a helping hand in the market? Members of Inside the Income Factory get exclusive ideas and guidance to navigate any climate. Learn More »

Young Business Boy Making Pound Sterling

Typical INCOME FACTORY® investor

RichVintage/E+ via Getty Images

Readers know by now that I don't believe in "being a hero" when it comes to investing. But I also can't afford to just move to cash or buy 2% Treasury bonds when times get scary and uncertain.

Like right now, when markets are gyrating all over the place as investors respond to the war in Europe, lingering Covid supply chain and medical issues, and - especially - concerns about inflation, interest rates and how Fed actions or inactions will affect our markets and economy.

Whew! That's a lot to worry about. So, without knowing what the future holds, but needing income, I'm looking for investment bets that will still pay off if all our economy does is hold itself together while corporate America muddles through, pays its debts and pretty much just continues on as it has been.

That's not an unreasonable expectation. During the 2008/2009 financial crash, investors who held on tight came through OK. While a record 10% of companies defaulted, the other 90% came through fine while their stock prices dropped to bargain levels for the investors who stood firm and reinvested their dividends. The Covid and energy-induced crash of 2020 turned out even better for investors who stayed the course.

"Staying the course" for me, in this current environment means finding investments that:

  • Pay me a high, dependable current cash yield, so I don't have to count on their stocks going up to achieve my target equity return of 9-10%
  • And will also keep up with inflation and the higher interest rates that generally accompany it

Barings BDC Fits The Bill

One firm in particular that fits my desired profile is Barings BDC (NYSE:BBDC), which is a business development company ("BDC") owned by Mass Mutual Insurance. A BDC is essentially a virtual bank that specializes in corporate loans, generally to medium to smaller companies. The loans are almost invariably secured, which means that even when they do default, as some loans always do, the lender is first in line at the recovery table or in the bankruptcy court, and on average collects about 75% of principal.

That means that if typical default rates for corporate America are about 3%, then a typical corporate loan portfolio might have 3% of its loans default, but since its collateral security interest provides it with an average 75% recovery, the loss per defaulted loan is only about 25%. You put that all together and it means that if 3% of your portfolio's loans default and you lose an average of 25% on each one of them, then your overall loss is only 3% times 25% which equals 0.75% of your portfolio. So a secured loan portfolio, that might be collecting interest at a rate of say 7%, would - at typical default and loss rates - see less than 1% of its overall portfolio yield written off for loan losses.

But in fact, corporate loan defaults have recently been much lower than that, with default rates currently at their lowest rate in a decade, at 1.2% per annum as just reported by Moody's Investors (MCO). At that rate, a typical secured lender's portfolio loss would be even less, or 25% times 1.2%, for a net portfolio credit loss of 0.3%.

BBDC's loan portfolio looks very healthy. Its latest quarterly report shows no loans on non-accrual in its "legacy" portfolio, with all the non-accruals appearing in two portfolios it recently acquired, where the potential problem loans were identified upfront and/or are covered by some sort of "support" agreements from the sellers. These non-accruals comprise a relatively modest 1.6% of BBDC's overall portfolio, and we should remember that just because a loan may be on non-accrual doesn't mean it will default or turn into a loss.

Besides being secured, the loans are floating rate, at a spread over a base rate that increases every month or quarter (depending on the loan contract) as interest rates rise generally. That gives me the inflation protection I want (since interest rates rise with inflation).

The two features - security plus floating rates - are a perfect combination for an inflationary economy. Inflation not only puts upward pressure on interest rates, the higher prices also dampen economic activity, putting pressure on many companies' sales revenues and earnings. That means default rates could rise, which is where the secured lender, as we saw earlier, has a real advantage over other unsecured lenders and creditors, since whatever defaults secured lenders suffer result in much smaller hits to their bottom line, after factoring in the beneficial effects of the collateral security.

The Secret To Credit Success: Expertise Plus Collateral

Firms like Mass Mutual Insurance, as well as other old line insurance companies like Prudential (PRU) and John Hancock, have known for generations how to extend credit to corporations, and - especially - how to tie them up with collateral security agreements and sometimes other "restrictive covenants" that give lenders the power to enforce their rights before the borrower's financial situation deteriorates irremediably. That's the expertise that Mass Mutual brings to its operating units like BBDC, as well as to its other units that engage in corporate credit, like its highly regarded funds Barings Corporate Investors (MCI), which has been doing it successfully since 1971, and Barings Participation Investors (MPV), which has been doing it since 1988.

While Mass Mutual began in 1851, BBDC's original predecessor firm started back in 2007; but it wasn't taken over and re-started - essentially from the ground up - by Mass Mutual until 2018. So it's a relatively young operating unit, although built on a rich heritage and a highly respected credit shop. It's published (by third party sites) 10-year annualized earnings rate (which is pretty meaningless, given Mass Mutual's only recent involvement) is a rather sedate 7.2%, measured on its net asset value (i.e. the company's book value). But the stock market has not been kind to BBDC, so its 10 year annualized return on market value has only been a rather anemic 3%. What that means is the market has steadily undervalued the firm's performance (both before and after Mass Mutual's takeover) to the point where its market price currently represents a discount of 15% to its net asset value.

While BBDC's longer term performance has been underwhelming, its more recent performance, along with its outlook, parentage and support from the institutional investment community are what make me so comfortable and supportive of it going forward.

Over the past year:

  • BBDC's total returns have been a robust 10% on its net asset value and 5% on its market price; again the familiar pattern of the management doing a good job earning 10% on the actual assets they have to work with (i.e. the net asset value), but the market not appreciating it so much.
  • That's not so hot for existing shareholders just looking at market performance, but again - by keeping the stock at a generous 15% discount - makes it all the more attractive to new buyers
  • For the 2022 year-to-date, while the market averages have been plummeting, BBDC has actually continued to earn a profit of 2% on its net asset value, although its total return on market value is down 7%, not as much as most market averages, but still a negative.
  • Meanwhile, shareholders have been enjoying a steadily rising dividend yield, currently 9.5%
  • More important, that dividend yield hasn't been rising just because of price drops, like so many other stocks and funds
  • Rather BBDC's actual dividend payments, which had been somewhat volatile for the first decade or so of its life, have been on a consistent rise for the past 4 years (most recently this month, by 4%), as this chart shows.

Dividends

Barings

This augurs well for future dividend yields, particularly when we consider that BBDC's loan portfolio, based on floating rates, will increase its average coupon over time as it adjusts the interest rates on its customers' loans to match any inflation-driven rise in interest rates.

Investing As A Group Activity

To me, this is the perfect time to invest (at a discount!) in an unspectacular but well-run company with a strong parent and rich heritage, as well as a generous 9.5% dividend that gives me my entire "equity target" return without having to worry about any market appreciation.

But I'm not the only one who sees value in BBDC, both as a long-term investment and - especially - during a volatile period like we're now going through. BBDC has an impressive institutional ownership line-up, with 43% of its shares owned by large institutional investors or mutual funds. Included among them are the following major institutional investors:

  • Barings (its parent, a subsidiary of Mass Mutual), with $141 million worth, or 12% of BBDC
  • Ares Management, with $56 million, almost 5%
  • Punch investment Management, with $28 million, about 2%
  • UBS Financial Services, also $28 million, 2%
  • Relative Value Partners, $16 million, 1.3%
  • RiverNorth Capital Management, $14 million, 1.2%
  • Cliffwater, $14 million, 1.2%
  • Doubleline Capital, $13 million, 1.1%
  • Wells Fargo Advisors, $10 million, 0.9%

That's only some of it; the rest are listed here.

Bottom Line

When I put all this together:

  • Really solid sponsoring organization (Mass Mutual/Barings) with a long history of success in the corporate credit area
  • Steadily growing dividends over the past 4 years, even through the Covid crisis
  • A credit portfolio well positioned to withstand the impact of inflation and rising interest rates
  • A generous 9.5% yield (positioned to rise as earnings grow and/or with inflation) that provides an "equity" level of return even if the stock doesn't appreciate and/or the overall market continues its volatility
  • The margin of error that a market price at a 15% discount to the firm's net asset value provides
  • And a blue-chip roster of fellow investors who have come to the same overall conclusion about BBDC that I have.

I see this as another "sleep better at night" investment of the sort I have written about recently, that should help us ride out whatever shocks - known and unknown - remain ahead of us.

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This article was written by

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Bavaria introduced the Income Factory philosophy in his Seeking Alpha articles over the past ten years, drawing on his fifty years experience in credit, investing, journalism and international banking. His earlier book "Too Greedy for Adam Smith: CEO Pay and the Demise of Capitalism" exposes the excesses in the CEO pay arena. Both books are available on Amazon. 


Bavaria began his career at the Bank of Boston, handling international credit workouts that included managing a fleet of ships, chasing a Vatican-owned bank in Switzerland, and leading the turnaround of troubled branches in Australia and Panama.

Later he worked at Standard & Poor's, where he introduced credit ratings to the leveraged loan market, helping to open the loan asset class to pensions, mutual funds and specialized investment vehicles like CLOs.

Bavaria graduated from Georgetown University and New England School of Law. He lives in Ponte Vedra, Florida.
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Disclosure: I/we have a beneficial long position in the shares of BBDC either through stock ownership, options, or other derivatives. 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.

Additional disclosure: My articles published on Inside the Income Factory or elsewhere on Seeking Alpha, including comments, chat room and other messages, represent my own opinion based on personal knowledge and experience. I am not an investment “expert,” counselor or professional advisor, and while my articles may reflect substantially the strategies I employ in my own investing, there is no assurance that these strategies will be successful, either for me personally or for my readers. In other words, while I do my best, there is no warranty or guarantee that the ideas expressed are correct or accurate, and I urge all readers to take my opinions for what they are – “opinions” – and to do your own due diligence on, and check out personally, every investment idea, stock or fund that I may present, so you can make your own informed decisions.

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