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Darren415

We have recently seen a significant uptick in issuance of BDC baby bonds and we take this opportunity to discuss these new issues and highlight our views. We also discuss the key criteria for gauging the risk/reward in the sector.

BDC baby bonds are attractive assets in the current environment for several reasons. First, they tend to have decent quality. By "decent" we mean the quality sweet spot where they are not so high-quality as to have unattractive yields and yet not so low quality as to cause particular concern about the return of principal.

Second, these bonds tend to have relatively low durations. This is attractive on two fronts - because of the inverted yield curve and because of fairly tight corporate credit spreads. An inverted yield curve means 3-5Y bonds (the sweet spot in BDC baby bonds) will offer higher yields than 10Y+ bonds, all else equal. And in case credit spreads back up substantially, their prices should be more contained than longer-duration assets.

It's particularly good to see new bonds in the current environment as credit valuations are fairly rich. These bonds can allow investors to take some chips off the table while retaining high single-digit yield exposure. These assets fall into our "drier-powder" asset allocation bucket which we have been growing recently in our Income Portfolios in response to fairly frothy markets.

In this section, we revisit the definition of drier-powder assets like BDC baby bonds and the important role they can play in income portfolios.

There are many ways to construct and manage income portfolios. One is to be fully invested at one's maximum risk appetite at all times. This is a common way for income investors to run their portfolios because it's the way to maximize yield - doing anything else feels like leaving money on the table. And as the refrain goes - it's hard to beat "cold hard cash" in your pocket.

The trouble with this view, however, is that strictly focusing on yield often comes at the cost of ignoring the capital base. And, we would argue, what ultimately builds wealth is a sustainable base of capital rather than "cold hard cash". The income world is littered with high-yielding securities that have left investors with a hole in their portfolios that will take time to heal.

This is why we prefer to build income portfolios that also feature potentially resilient holdings alongside higher-yielding ones. We call these resilient assets - drier-powder assets. The reason we use the word "drier" rather than "dry" is simple.

In our view, truly dry powder assets are few and far between and those that do exist such as TBills offer significantly less yield, lock up your cash for a certain period like CDs and face reinvestment risk if the Fed were to push rates lower over the medium term.

The point here is not that investors should avoid cash-like assets but that there are other quality assets that offer higher yields, good liquidity, potential capital gains and much less reinvestment risk.

An important feature of income markets is the simple fact that they tend to be highly mean-reverting. We can see this in metrics like corporate credit spreads below.

FRED

We can also see this by looking at CEF discounts below.

Systematic Income

What this suggests is that as income markets get towards a more expensive valuation, it makes sense to increase the amount of drier-powder assets to take advantage of a potential sell-off.

Four further points are worth making. First, markets make this countercyclical allocation approach a lot simpler for income investors because, typically, different parts of the market co-move i.e. credit spreads, discounts and equity prices tend to be highly correlated. This means that, more often than not, credit spreads, stocks and discounts are all expensive or cheap at the same time.

Second, for investors to follow this approach, it's important to get an intuition of the potential upside. For example, an investor who holds 7-8% yielding drier-powder assets versus holding a 10-11% yielding asset misses out on roughly 3% each year. However, if significant drawdowns happen every 1-2 years and if drier-powder assets can outperform higher-beta / higher-yield assets by 10-15% during the drawdown (allowing the investor to rotate to higher-yielding assets) then that can add a significant boost to investor's longer-term wealth and which, of course, can then drive a higher level of income.

Third, using drier-powder assets as a strategic part of income portfolios can also reduce volatility. Some investors pooh-pooh managing portfolio volatility, however, the reality is that it is much easier to lose conviction in a portfolio and hit the sell button during a drawdown when losses are magnified. Drier-powder assets can help keep portfolio drawdowns in check which, in turn, can help investors remain invested during drawdowns rather than repeat the usual cycle of selling low and buying back higher.

Fourth, the yields of many very high-yielding securities can be illusory. This may be because of something plain like overdistribution that is very common in high-yielding CEFs or the obvious fact that higher-yielding securities also carry additional risk so investors shouldn't simply bank the higher yields with the assumption that it's all money good.

This year, we have seen bond issuance from the following BDCs:

The key metrics of these bonds are shown in the extract below from our service Baby Bond Tool.

Systematic Income Baby Bond Tool

When evaluating the risk / reward on offer, it's important to identify the key quality metrics of any given bond. For the BDC sector these are the metrics we tend to focus on.

Given these metrics, we see value in both CSWCZ as well as SAZ.

Both companies have seen stability and resilience in the NAV. The CSWC NAV has been relatively stable and the SAR NAV has been rising over the last 8 years or so. Both have recovered at least in part from drawdowns such as early 2020.

Systematic Income

Both portfolios are allocated primarily to first-lien loans - 85% for SAR and 87% for CSWC - above the average in the sector.

CSWC

CSWC leverage is very low by BDC standards at 0.9x while SAR leverage is quite high at almost 1.8x. This is a metric worth watching for SAR however there are several mitigants for it such as the company's strong underwriting track record which has resulted in net cumulative realized gains, very little secured debt in front of the bonds and relatively high yield on the bonds.

Finally, turning to the position of unsecured debt in the liability stack, as just highlighted, the SAR bonds have a favored position with only a $35m credit facility vs. around $790m of bonds. CSWC has a relatively small credit facility of $195m vs. $476m of bonds. This is relative to the average BDC where bonds and credit facilities are about evenly split. A smaller credit facility means the unsecured bonds have a claim to more assets than would be the case otherwise.

Of the new bonds, CSWCZ and SAZ look most attractive to us. They are trading at yields around 8% and 8.7% respectively - these are not the highest yields on offer in the sector however they do offer the best risk/reward in our view.

Check out Systematic Income and explore our Income Portfolios, engineered with both yield and risk management considerations.

Use our powerful Interactive Investor Tools to navigate the BDC, CEF, OEF, preferred and baby bond markets.

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This article was written by

At Systematic Income our aim is to build robust Income Portfolios with mid-to-high single digit yields and provide investors with unique Interactive Tools to cut through the wealth of different investment options across BDCs, CEFs, ETFs, mutual funds, preferred stocks and more. Join us on our Marketplace service Systematic Income.

Our background is in research and trading at several bulge-bracket global investment banks along with technical savvy which helps to round out our service.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of SAZ 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.

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.