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Income Investing: How to Pick the BDCs With the Safest Yields And Best Loan Books -- Barron's

Dow Jones Newswires ·  Feb 20, 2021 10:30

DJ Income Investing: How to Pick the BDCs With the Safest Yields And Best Loan Books -- Barron's


By Alexandra Scaggs

Income investors may want to pay attention to business development companies' earnings this month: Those that report stable loan portfolios could deliver some healthy yields.

The vehicles, known as BDCs, are among the only ways that individual investors can lend to midsize companies that are too small for traditional bond offerings. BDCs generally raise money in both equity and bond markets and lend to those companies directly, or buy their loans.

The draw for investors is that these midsize companies pay higher yields to borrow than bond-market giants like Apple (ticker: AAPL) or Microsoft (MSFT). And BDCs have similar dividend rules as real estate investment trusts: They must pay out 90% of their net income as dividends to get preferential tax treatment. The Cliffwater BDC Index yielded 9.1% as of Feb. 17.

By contrast, long-term Treasuries yield around 2.1%, even after a steady drive higher over the past four months. The investment-grade corporate bond market yields less than 2%, and junk bonds yield less than 4%. In all three of those markets, interest rates are fixed, so rising yields and interest rates can dent returns.

BDCs, however, often lend at floating rates. That means that if short-term U.S. interest rates eventually rise, those loans' interest rates will rise, as well. That might be years away, but it does help investors dodge risk of paper losses that hit fixed-rate bonds when yields rise.

The downside is that midsize companies pay higher rates for a reason. They are smaller and tend to be less insulated against business disruptions of the type that happened during the pandemic. As of the third quarter of 2020, about 4.5% of the loans in BDC portfolios tracked by analysts at Truist were overdue by 90 days or more, the highest in four years, according to a recent note. That compares with about 1.6% before the pandemic, the analysts wrote.

That makes it important for investors to be careful in choosing managers, says Andrew Kerai, portfolio manager and senior credit strategist at RiverNorth. Until the middle of last year, Kerai, who helps manage the RiverNorth Specialty Finance fund (RSF), was interested primarily in BDCs' unsecured bonds, in part because the sector has leverage limits imposed by regulators.

But when the sector's equity started to sell off, the fund started to buy more shares, as more BDCs traded at a discount -- and with hefty yields.

"On the equity side, I think our strike zone is a lot narrower than some people's," he said. "It's got to be a top-tier manager, a [loan] book that's good quality, with good liquidity and trading at a reasonable discount. Coming into Covid-19, all those things were all hard to find."

As of Sept. 30, 2020, the fund owned shares of seven BDCs, including Oaktree Specialty Lending (OCSL); MVC Capital, which has since merged with Barings BDC (BBDC); Bain Capital Specialty Finance (BCSF); and Ares Capital (ARCC), according to Securities and Exchange Commission filings. About 14% of its fund was invested in BDC shares, compared with 40% in bonds issued by BDCs. But those bonds generally offer lower yields than the shares; most yield less than 5%, and many yield less than 3%.

Investors may have missed out on the steepest discounts on the equity side. BDCs' valuations are no longer weighed down by a wide investor panic the way they were during the height of the Covid-19 scare last March. The Cliffwater BDC Index was recently trading at a discount of 0.6% on Feb. 17, compared with discounts of nearly 50% last April.

There are still a few factors that could work in BDCs' favor from here, however. Perhaps the biggest is a rally in risky debt that has pushed yields on low-rated bonds lower. Bonds rated CCC+ or below -- the lowest-rated bonds not in default -- have rallied 2.4% for the year through Wednesday, according to ICE Indices. That outperformance may bode well for BDCs, seen as one step down in credit quality and size, according to strategists at credit-research firm CreditSights.

And credit quality might be starting to look brighter in private markets, where lenders are seen as being more willing to negotiate with borrowers to amend loan terms and avoid messy defaults. According to law firm Proskauer Rose, the default rate for the fourth quarter of 2020 was 3.6%, down from 4.2% the prior quarter and 8.2% in the second quarter of last year.

In fact, analysts have been pointing to a very different type of risk for BDCs and private lenders more recently: the risk that borrowers will start paying back loans early, removing sources of yield sooner than expected. Those risks are offset with fees, particularly for younger loans.

"While we expect repayment activity to increase going forward for all BDCs, the younger the portfolio, the greater the probability that a repayment will generate more material yield enhancement income (prepayment fees, accelerated amortization) that flows to earnings," wrote Robert Dodd, analyst at Raymond James, in a December note on the sector. As of that note, the two BDCs with the "youngest" portfolios were Barings BDC and Owl Rock Capital (ORCC).

BDCs might also find more opportunities to make new loans at rates that are attractive to investors, says Truist. In a Feb. 4 note, the bank's analysts said they favor Ares Capital, FS KKR Capital Corp. II (FSKR), Owl Rock Capital, and Sixth Street Specialty Lending (TSLX), the last of which pays a variable dividend.

More recently, earnings have been in focus, and the news seems to be good there, as well. Of the roughly dozen BDCs that had reported earnings through Feb. 11, according to Dodd, the share of portfolio loans with late payments has declined to close to 3%, down from levels above 4% the prior quarter.

"Credit quality looks to have broadly improved and is quickly coming back to pre-Covid levels, if not even better," wrote Dodd.

Even so, there are plenty of reports yet to come, with 38 BDCs in Cliffwater's index. And the performance of different managers' portfolios can vary a lot. So, investors should stick with BDCs with proven track records and strong management teams, and not be lured into higher-yielding names trading at steep discounts.

"Only pick the top-tier names," Kerai said. "Don't ever stretch for lower-tier names, and don't ever stretch for yield." b

Write to Alexandra Scaggs at alexandra.scaggs@barrons.com

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(END) Dow Jones Newswires

February 19, 2021 21:30 ET (02:30 GMT)

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