Macro

The high yield spread, as shown by the St. Louis Fed graph below, has improved significantly since it blew out in March’s COVID-19 crash. Thus, the spread is nowhere near the 8%+ peaks (vertical green lines) which have previously marked particularly attractive Business Development Company ‘BDC’ buying points.

Source: St. Louis Fed and Google Finance

Recently, however, the BDC sector has gotten cheaper with price declines carrying the Wells Fargo BDC ETN (BDCS) to an almost oversold position (36 RSI).

Source: Yahoo Finance

The main fear prompting the most recent dip is essentially the same as March’s. Namely that a double dip COVID-19 induced recession could cause numerous debt defaults among the middle market companies that BDC’s lend to.

This in fact might happen this winter, and frankly knowing whether it will is a key risk to all BDCs. Management teams may rate how many of their loans are currently in trouble, but there’s little ability for the analyst to second guess this judgment, nor do the risk ratings say as much about future loan viability as we’d like them to. For this reason, combined with the leveraged nature of BDCs, Cash Flow Kingdom decided to lower its risk rating on just about every BDC name it covered when COVID-19 first hit. We also placed the overall sector on hold, and have been pretty much sitting on the sidelines ever since.

We don’t deny everything will eventually be just fine, in fact we are generally some of the more optimistic people we know regarding the US getting past COVID-19. Further, we acknowledge if we can pick the right firm and time it decently, specific BDCs will end up being quite a bargain. The phrase, “Be Greedy when Others or Fearful” still applies. However, we contend first you need to be pretty sure any firm under consideration is going to last until the recovery, and there’s simply more ability to do that in other spaces right now than there is with leveraged financial firms.

In our opinion, there are other sectors which offer just as much upside potential and income as BDCs, yet also the ability to better analyze firm survivability and the maintenance of underlying value. Given we chose not to step in even when the High Yield spread was clearly signaling buy, we see even less reason to do so now.

In addition, we also note the Fed keeping interest rates lower for longer does not bode well for the BDC sectors’ near term income generation. The flexible rate, lending-based nature of BDC income streams means revenue becomes challenged when rates are low. Thus, an optimal time to invest or increase one’s position in a BDC may be not just when it’s cheap, but also when there’s more potential for the income stream to improve thanks to increasing rates. When that occurs not only are the names cheap but the income stream is likely to go up, thereby triggering an adjustment in equity price.

In short, if you feel the end of the recession is right around the corner and are willing to buy in the face of fear, there are BDC names which seem quite attractive.

Source: Stock Rover

For instance TCG BDC Inc. (CGBD), also known as The Carlyle Group BDC would likely do well in such a rebound situation.

The Carlyle Group BDC

TCG BDC Inc. is relatively new to being publicly traded (June 2017); however, it was started by private equity firm The Carlyle Group (CG) as a private BDC back in March 2013. Carlyle itself has been in this business for over 28 years, investing more than $90 billion in various firms during that time. So, while unknown to many individual investors, CGBD’s manager is highly experienced, and now that initial lockup periods are behind us, there is no longer that pressure on the shares.

As of this writing, CGBD offers a very attractive 16.3% distribution which was covered at 1.14x last quarter (18.6% NII yield). Furthermore, if purchased before Tuesday, the investor will qualify for the latest 37¢ payout (4% of purchase price). However, on average, the NAV of CGBD has dropped about 3.6% per year due to the occasional write-off.

Source: Company 10-Qs

So, in my opinion one needs to subtract that to derive a combined internal return expectation around 12% – 13% (a.k.a. economic value added = 16.3% distribution – 3.6% NAV attrition). This is still an attractive expected internal return, but it doesn’t say anything about near term price nor Mr. Market’s reaction to challenges such as COVID-19.

The potential investor needs to understand that CGBD while well run, does not maintain the lowest risk portfolio and the management is external. Thus, it stands to reason that the riskier the portfolio the more price volatility the investor is likely to experience were a COVID-19 double dip or other challenge to occur. Additionally, Mr. Market can send equity prices up and down for reasons that have nothing to do with the underlying company’s long-term internal returns and fundamentals.

Risk

I wouldn’t call any BDC low risk; they are after all leveraged financial investments. However, when well run by experienced, well-aligned management, they can provide attractive returns and quite attractive income streams for the risk being taken on.

The trick is in picking the list of investible BDCs in the first place, then deciding whether the macro environment is such that you want to add to the space, and only then coming up with some method to decide which of these prescreened firms you feel currently offers the best risk vs. reward.

As previously indicated, we pretty much lowered the risk rating on all our BDCs when COVID-19 hit. In CGBD’s case the reduction was a bit more than some of the other BDCs we cover, from B all the way down 3 steps to C.

Source: Cash Flow Kingdom Tracker Tool; Company Earnings Reports and 10Qs

This is because CGBD’s portfolio can be a bit more subject to write-offs, with their NAV history showing more attrition than some of the other firms we cover. We stress this is not due to bad management, rather it is a mostly conscious choice management makes on where to place their portfolio on the risk scale. Over time a 16% yield with 3% attrition will achieve greater returns than a 9% yield with no attrition (albeit usually with higher volatility).

About 70% of the money CGBD lends is in 1st lien position with a 7.3% average yield (recently brought down from their more typical 8.5% – 9.5% as a result of seeking lower risk investments). And it should be noted that according to Moody’s, even when debt in this position defaults, it averages a pretty high 93% recovery rate. So CGBD’s portfolio isn’t risky compared to the average BDC, it’s just a bit riskier than the average BDC we happen to cover.

Almost all the loans the firm makes are floating rate (99%), indicating there is little rising interest rate risk. Indeed, a 1% increase in interest rates is a benefit, with the resulting Net Invested Income expected to increase by about 6%. However, this sword cuts both ways as a 1% decline in the average interest rate would normally be expected to reduce income by about 6%. In this case, however, CGBD and most BDCs are well into minimum payment floors meaning the underlying revenue stream is unlikely to go down much further due to interest rate declines. 4.6% of CGBD’s portfolio is rated higher risk by management with 3.7% currently on non-accrual status (not making their payments). While elevated, this is not an existential threat nor even a particularly scary level of non-accruals. Again 70% of the portfolio is first lien with an expected ultimate recovery level of 93%, and in this case that 3.7% in non-accrual is AFTER having already written down those loans by over a third. In other words, given historic recovery levels, the current non-accruals have already been written down to a level that represents expected recovery after bankruptcy.

Timing

BDCs have been falling recently along with the general market, despite never really having fully recovered from March. At first everyone sells whatever they have fairly indiscriminately. Then panic starts to dissipate, and we make more selective decisions regarding which firms probably won’t be as badly affected as initially feared.

For the BDC sector, Mr. Market (and I) judged at least some of that fear remains justified. Once again, the simple fact is one really doesn’t have all the necessary information to judge which firms in a BDC’s overall portfolio are likely to default were a double dip COVID-19 induced recession occur. Thus, one is mostly left having to handicap COVID-19 effects on the economy, and trust management’s ranking of changes in individual loan risk reflects some of that risk (another reason you need to have confidence in management alignment). With other sectors, such as natural gas midstream (hint), or even specific hospitality plays with strong balance sheets and good cash flow characteristics, one can have more confidence in the firm’s survival and long-term retention of value than with leveraged BDCs. This doesn’t imply one should avoid the space, but rather that knowledge and timing are going to matter even more here. Or put another way, I’d rather err towards be late to a BDC recovery than early.

Historically, we’ve already seen BDCs are trading near an oversold condition, and I can tell you CGBD’s current indicated regular forward yield is at the upper end of its range.

Source: Company Presentation

What we don’t know is have we seen the bottom yet or will a second round of COVID-19 induced pain take the firm back to March lows?

To be fair, management is backing up their opinion that the firm is priced attractively with action. They bought 70,000 shares back in mid-March, including a notable 33,000 share purchase by the CFO in the low $7’s (we always pay more attention to CFO purchases). More recently the Chief Investment Officer followed this up with another 25,000-share purchase in August (at $9.20 per share). Additionally, the firm has already used up much of its $100 million buyback authorization, commenting in the last conference call,

With our improved liquidity position, going forward, we intend to pursue the appropriate balance of both share repurchases and attractive new investment opportunities….We have about $14 million left on our share repurchase program, and we’re likely to go back to the board to re-up that. But what we want to do is there’s still a lot of uncertainty, so we do want to make sure that we’re being balanced, and how we use our cash and how we protect our balance sheet. But as I said, we do think our stock is a pretty good buy, but we don’t want to get too far out over our skis. We like where our balance sheet is positioned, and there’s still a lot of uncertainty in the market so we do want to approach it pretty cautiously.

Thus, we acknowledge CGBD is currently priced at an attractive 36% discount to book as well as a P/TB that is historically pretty low for them.

However, the firm has also partially recovered from March lows.

Source: Yahoo Finance

It isn’t quite trading at the oversold condition where we like to buy, yet there are multiple opportunities to buy oversold firms elsewhere. Thus, we have not been adding to our current relatively small position in this name.

Conclusion

The decision to hide in cash or be greedy where others are fearful is up to the individual reader’s risk tolerance. I therefore can’t say which is correct for you. However, it’s pretty clear there is fear in the streets, and when one waits until optimal conditions are reached, they frequently miss out on some of the better buying points.

Yet, I’d also caution there are probably more optimal places to invest right now than BDCs and in my opinion more optimal BDCs to invest in than CGBD. That’s not to say it’s a bad firm. I actually own some of it and would add to build a more meaningful position when the time is right. I just don’t think now is the right time for me. This is in part due to more attractive opportunities which exist elsewhere.

If you do choose to initiate or add to existing positions in BDCs, it makes sense to ease into well run BDCs when they fundamentally appear both cheap and oversold. Then add to those positions when either the high yield spread increases above 8% or you think interest rates are likely to increase in the near future. You almost certainly won’t capture the bottom with this strategy. However, by getting more of our money in towards the bottom when shares are cheap (buy low), and cashing in dividends on regular basis (sell high), you should do just fine.

We, at Cash Flow Kingdom, choose not to specialize in any particular industry, but rather invest in a variety of sectors. This gives us the option to overweight some and underweight others according to each sector’s specific prospects. We can do this in part because we stand on the shoulders of others.

In the BDC space we recommend and are members of BDC Buzz’s service. After having subscribed to more than a dozen different investment services– on Seeking Alpha, the internet, and via Wall Street –we are confident he provides the most useful analysis in the BDC arena.

By combining a number of well covered and different revenue streams, the Cash Flow Kingdom Income portfolio has been able to produce this actual, real life payout.

Source: Etrade

“Is this the kind of steady income stream that would help you sleep well at night?”

Disclosure: I am/we are long CGBD. 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: This analysis was provided at the request of Seeking Alpha; however I wrote it myself, and it expresses my opinion only. CGBD is a risky investment. We do not know your goals, risk tolerance, or particular situation; therefore, we cannot recommend any specific investment to you. Please do your own additional due diligence.

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