A Quick Introduction to Business Development Companies (“BDCs”)
Business Development Corporations (“BDCs”) invest shareholder capital in small and medium-sized privately held US companies. BDCs aim to generate income and capital gains when the companies they invest in are sold, much like venture capital or private equity funds. Anyone can invest in BDCs, as they are public companies listed on major stock exchanges.
BDC Investment Grade Bonds/Notes
Many BDCs offer investment grade (“IG”) bonds/notes for low-risk investors who don’t mind lower yields/returns. Thanks to the recent declines in fixed income, the traditional bond market is now offering excellent value, especially in the BDC sector, and I’ll talk about that over the next few weeks. However, many of these bonds are now bouncing back and I have started buying medium duration maturities, which for me is between 3 and 6 years.
Traditional bonds do not trade on an exchange, but are available through your brokerage using CUSIP numbers with a face value/maturity of $1,000. These bonds pay interest semi-annually with a prorated interest payment on the date of purchase. Brokerages express trading prices as a percentage of face value.
As discussed below, ARCC’s 2031 bond is currently priced at $79.71, implying a present value of $797.10 for each bond. For more information on examples of bond trading using CUSIP and limit orders, please see the following link.
Most BDC bonds have credit ratings from Moody’s and/or S&P and so far no BDC has ever defaulted for the reasons discussed last week in:
- Recession Resistant with Investment Grade Bonds
As shown below, BDCs are highly regulated with many protections for investors in common stocks and debt securities, such as the amount of leverage (asset coverage ratios discussed later), the asset diversification and having a portfolio that can “generate enough cash flow to pay interest as well as dividends to equity investors that are subordinate to debt holders”:
Ares Capital Investment Grade Bonds
Ares Capital (NASDAQ: ARCC) has 9 investment-grade bonds (CUSIP: 04010LAU7, 04010LAX1, 04010LAV5, 04010LAY9, 04010LAZ6, 04010LBA0, 04010LBD4, 04010LBB8, 04010LBC6) that are rated by both S&P, Fitch and Moody’s:
As discussed in the previously linked article, the “asset coverage ratio” is a financial metric that measures a company’s ability to service its debts by selling or liquidating its assets. The higher the asset coverage ratio, the more a company can cover its debt. Therefore, a company with a high asset coverage ratio is considered less risky than a company with a low asset coverage ratio. BDCs are required to maintain a minimum asset coverage of 150%, providing strong protection for bondholders, which is one of the reasons why no publicly traded BDC has ever filed for bankruptcy or default to bondholders in the history of the sector.
As of June 30, 2022, ARCC’s asset coverage ratio was 178%. However, on August 2, 2022, ARCC issued 9,200,000 shares at a price of $19.00 per share, generating net proceeds of approximately $174.4 million, after discounts and commissions and offering costs. estimated.
As shown below, the the pro forma asset coverage ratio would be closer to 183% but of course does not take into account other changes, including portfolio growth or exits.
The “Interest Expense Coverage” ratio is used to see how well a company can pay interest on outstanding debt. Also known as the ratio multiplied by interest earned, this ratio is used by potential creditors and lenders to assess the risk of lending capital to a business. A higher coverage ratio is preferable, although the ideal ratio may vary by industry. When a company’s interest coverage ratio is only 1.5 times or less, its ability to meet interest charges may be in question.
ARCC’s interest expense coverage ratio has historically averaged approximately 3.4 times, as shown below:
BDC’s interest rate sensitivity leads to higher dividends
As predicted in previous articles, many BDCs have announced dividend increases in recent weeks partly related to rising interest rates. My article last month “Fixed 6.5% Return On Main Street’s Investment Grade Bond” mentioned the following:
There is a good chance that many BDCs will increase their dividends over the next few quarters, especially since the Fed will likely raise rates another 75 basis points today. [July 27, 2022]resulting in a significant improvement in this analysis for most BDCs
Interest rate sensitivity refers to the variation in earnings that may result from changes in interest rates. As of June 30, 2022, 74% of ARCC’s portfolio investments bore interest at variable rates, 10% at fixed rates, 16% either did not earn interest or were not accounted for. The Revolving Credit Facility, Revolving Funding Facility, SMBC Funding Facility and BNP Funding Facility bear interest at variable rates with no interest rate floor. The unsecured notes and the 2024 convertible notes bear interest at fixed rates.
Based on our estimates of increased earnings through higher interest rates, coupled with the strength of our investment portfolio, we have increased our regular quarterly dividend to $0.43 per share. Our balance sheet remains a notable source of strength with ample liquidity, moderate leverage, and more than 70% of our outstanding debt in long-term, fixed-rate unsecured notes. Market rate increases in the second quarter have not yet fully passed through to our earnings. We estimate that our second quarter earnings would have been approximately $0.05 per share higher had the market rate increases during the second quarter been in place for the entire quarter. We believe we are well positioned for our earnings to benefit from further increases in short-term interest rates.
The following table shows the change from Q4 2021 to Q2 2022 with the impact of a 100 basis point increase from an additional $0.03 per share of annual earnings (as of December 31, 2021) to $0.31 per share (as of June 30, 2022).
“We do not believe that a cycle of monetary tightening will have negative effects on us. Our large floating rate loan portfolio is funded primarily by fixed rate unsecured funding sources and our assets are largely floating rate investments. We believe this positions us well for our net interest income to benefit from rising rates.
Current Common Stock and Bond Yields
My previous best projections for the ARCC called for a regular quarterly increase to $0.43 per share for Q3 2022 and I expect another dividend increase for Q4 2022 partly tied to rates of higher interest but also to portfolio growth and/or additional income from Ivy Hill Asset Management (“IHAM”) in part due to the previously announced acquisition of Annaly Capital Management‘s (NLY) direct loan portfolio ):
We just did a really big deal there, obviously buying this wallet from Annaly. They acquired over $1 billion in assets. We have made a substantial investment in the business which is a bit of a needle mover for this quarter compared to others. In this quarter, we actually had a one-time, not necessarily expected, dividend from an equity investment in a holding company. But then the lion’s share of the increase, as you can probably expect, is our continued investment in Ivy Hill, which is bigger, it’s just going to pay us a bigger dividend going forward.
Previously, ARCC announced the $0.12 per share of “additional dividends” paid evenly each quarter for a total of $0.46 per share for the third quarter of 2022:
The “annualized” return shown below shows the actual composition of annual returns. This is the true return every year, which has averaged almost 22% over the last 9 purchases, even after taking into account the recent market pullback.
ARCC bonds maturing from 2026 to 2031 (4 to 9 years) were trading about 20% below par but started to rebound. For example, its 2031 bond was trading below 73 on June 30, 2022, and is now close to 80 but still yielding over 6%. Importantly, this is a nearly 10% gain (from 73 to 80) over the last 6 weeks and you still get a yield to maturity of over 6% for new purchases :
The following table comes from BDC Google Sheets showing ARCC’s obligations and I will continue to cover many other BDCs listed below, including their asset coverage ratios and interest expense.
Interestingly, many ARCC bonds currently have relatively lower yields for similar maturities, but likely related to higher quality and higher trading volumes/liquidity.
Conclusion – Risk Adjusted Returns
Given the uncertainty of future returns from stock/equity positions, I would suggest investors take this opportunity to lock in the 6% returns provided by the investment grade notes. ARCC is an investment grade company and investors can use a “barbell approach” by investing a portion in common stocks as well as investment grade bonds.
The main risk for the bondholder is a default of the ARCC, which is extremely low given the history/performance of the company:
- ARCC is one of the best BDCs with a long track record of returns over previous market cycles
- Debt coverage by assets is 183% and according to regulations must be at least 150%
- Interest expense coverage has averaged around 3.4x, which is much higher than most companies
- ARCC bonds are rated investment grade by S&P, Moody’s and Fitch
- No publicly traded BDC has ever filed for bankruptcy or had any bad creditors in the history of the industry
- ARCC’s stock is currently yielding 9% versus its bonds around 6% for an average of 7.5%