Co-produced with Preferred Stock Trader
The thesis of this article is that there are high yielding baby bonds in the market that are underpriced due to safety fears that are overdone. The baby bonds we are speaking of are one’s issued by BDCs. BDCs are legally required to keep leverage below certain limits for the exact purpose of keeping them out of financial trouble. This makes default on these baby bonds highly unlikely and thus makes them undervalued at their currently generous yields-to-maturity (YTM).
The market for fixed-income securities (baby bonds and preferred stocks) has been very strong with prices moving up quite rapidly. We are planning on making this article part one of a two-part article on fixed-income securities from companies with legal leverage limits. There is still a window to get some very nice bargains, but we are not sure how long this window will be open, so we are trying to highlight some of our investment ideas now while opportunities still exist.
In a zero-interest rate world, we believe that BDC baby bonds will ultimately go back to yield-to-maturities of 5.5 to 6.0%, as they were before COVID-19, and possibly even lower. And those who have locked in high yields now will be very pleased.
Since we are writing about bonds from 2 different companies, instead of the usual focus on one company, we will not be taking a deep dive into each of these companies. But we will provide the information necessary to make our investment thesis clear. If you wish to learn more about the companies that have issued these baby bonds, the companies’ websites and their 10-K SEC filings are good resources, as well as other Seeking Alpha articles.
Business Development Companies
Business development companies (BDCs) generally make loans to small and middle market companies. Because their loans are made to non-investment grade companies, the government has restricted the amount of leverage they can take on. The limit can vary depending on the type of debt the BDC has (SBA debt being the main variance), but leverage is generally limited to 67% of assets. If the BDC violates that leverage limit, then they must rectify that situation by raising cash (generally by issuing more stock) or by buying back debt in order to keep leverage below 67%. This keeps BDCs from getting into financial trouble that can harm their bondholders or preferred stockholders. We really love the BDC space for fixed-income securities because of the huge safety these leverage limits provide, and as many have mentioned before, no BDC baby bond has ever defaulted; but you wouldn’t know it judging from the yields currently offered on some BDC baby bonds.
1- MVC Capital Baby Bond (MVCD)
- Current Price $23.85 (May 28)
- Stripped Yield-To-Maturity 8.8%
- Maturity Date: 11/30/2022
- Call Date: Any time
- Annual Interest Payment $1.5625
- Ex-Dividend Dates: Last day of March, June, September & December
(price & yields based on market close May 28th)
MVC Capital is a business development company (‘BDC’) which has issued one baby bond, the MVC Capital, 6.25% Senior Notes due 11/30/2022 (MVCD).
MVCD is a very safe investment idea. This baby bond has an annual interest payout of $1.5625 and matures on 11/30/2022. For a relatively short-term and safe baby bond, it has an extremely attractive stripped YTM of 8.8% at a price of $23.85. Here is why we believe MVCD is so safe:
- MVCD does not have exposure to companies impacted by Covid-19. It has no loans to hotel or travel related companies, restaurants, retailers or companies in the entertainment and leisure sector.
- MVC (MVC) is one of the most conservative BDCs. MVC has a great balance sheet, in fact a balance sheet that is battling it out with GAIN as the best in the BDC space among those BDCs that focus on lending. Unfortunately, MVC’s most recent 10-Q is as of January 31st, so we don’t know their exact current situation, but looking at MVC’s latest quarterly report below, you can see that MVC has liabilities that are only 35% of assets despite being legally allowed to take on 67% leverage. Additionally, MVC has excellent liquidity with $45 million in cash and $25 million of its investment portfolio in treasury bills. Imagine a BDC having part of its investment portfolio in T-bills – now that is conservative. In fact, if MVC sold its T-bills and then applied the cash received to pay down debt, its liabilities would be only 19% of assets, much better even than that of GAIN.
Source: 10-Q Filing January 31, 2020
- In March, after this balance sheet was published, MVC made a partial call of $20 million of MVCD at $25.00. Buying back debt improves the balance sheet and any further partial calls on MVCD will just make this company’s balance sheet even better. Since MVC repurchased a portion of their MVCD bonds after the above balance sheet was published, their debt is even lower than the 35% number we referred to just above.
- As many of our subscribers and followers may already know, BDCs have leverage limits which keep them out of trouble. To date, a BDC baby bond has never experienced a bond default. MVC operates extremely conservatively and certainly will not be the one to break this BDC baby bond winning streak. To us, buying a relatively short-term baby bond with an 8.8% YTM in a sector that has never defaulted, is a no-brainer.
- Since the above quarterly report was issued, MVC announced that it has paid off the $25 million revolver that you see in the above balance sheet. So the MVCD baby bond is now their only debt, with no senior debt ahead of it. This adds somewhat to the safety of MVCD by being at the top of the capital stack with no senior debt. With no secured debt, MVC does not need to worry about debt covenants or getting permission from banks to buy back their debt or stock. Additionally, paying off the revolver again lower MVC’s leverage from what you see in the balance sheet.
- MVC has been buying back their common stock over the last 3 years yet keeping leverage extremely low. Unlike many companies who are externally managed, who take on more debt or issue more shares just to increase the size of the company they manage, MVC management has always acted in the best interest of the company and has not succumbed to the pressure to leverage up to increase fees. It is refreshing to see a manager that acts in the interest of the company and not its own interests.
Bottom Line for MVCD
In short, we believe that MVCD should be a core holding in anyone’s fixed-income portfolio. The current yield-to-maturity is very generous given the extreme safety of this company. Given the current zero interest rate environment, MVCD should be trading at 25.00 par.
2- Harvest Capital Credit Baby Bond (HCAPZ)
Harvest Capital Credit (HCAP) is also a BDC that loans to smaller size companies. It has issued one baby bond Harvest Capital Credit 6.125% Notes due 9/15/2022 (HCAPZ). Here are the stats on this baby bond:
- Current Price $23.61 (May 28)
- Stripped Yield-To-Maturity 9.6%
- Maturity Date: 9/15/2022
- Call Date: Any time
- Annual Interest Payment $1.53125
- Ex-Dividend Dates: Approximately February 28, May 29, August 29, and November 29
(price & yield based on market close May 28th)
HCAPZ has a high yield-to-maturity of 9.6% with the bond maturing in less than 2.5 years. At its current price, we believe HCAPZ also provides a good opportunity for some short term price upside as the prices of relatively safe fixed-income securities look to be marching back to par – as they have done in every other fixed-income selloff.
Source: 10-Q SEC filing date 3/31/2020
As of March 31st, 2020, HCAP had liabilities that are 54.5% of assets which is less than many BDCs and well under the legal leverage limit. Since the end of the quarter, they were able to use their restricted cash to pay down their revolving credit line from $44 million to $27 million. This lowers their leverage to 47.5% which is conservative leverage in the BDC world and well under the 67% limit. Additionally, HCAP is deferring dividends for April and May as a precaution and as bondholders we like that they are not distributing any of their cash right now.
In terms of their loans, we only see one loan in a sector that is hit by COVID-19. They have a very small $3.2 million loan to General Nutrition Centers. Little exposure to the sectors affected directly by COVID-19 is certainly important in these times.
As can be seen in the above chart, Chairman and CEO Joseph Jolson has made repeated buys of HCAP common stock during the period of March thru mid-May. We always like to see insiders having confidence in their company and believe it to be undervalued.
Bottom Line for HCAPZ
The bottom line with HCAPZ is that government regulation will not allow them to take on leverage greater than 67%. This means that the possibility of bankruptcy and bond default has pretty much been eliminated. Therefore, we feel that the 9.6% YTM is a great value . This baby bond traded at over $25.60 in February and we expect that HCAPZ will continue moving toward par.
** Note that HCAPZ will have gone ex-dividend between the writing of this article and its publication by Seeking Alpha.
The thesis of this article is that risk in baby bonds that have been issued by BDCs are misunderstood and overstated. This lack of understanding has created some excellent buying opportunities for certain BDC baby bonds.
MVCD is a BDC baby bond from an extremely conservative and low leveraged BDC. Additionally, BDC legal leverage limits add another huge layer of safety to MVCD. An 8.8% yield-to-maturity on such a safe baby bond looks like a bargain to us. We can also see a quick move up to par for a quick short-term gain. MVCD has already been partially called at par before COVID-19 tanked the market and it has no COVID-19 exposure.
HCAPZ offers a 9.6% yield-to-maturity which is quite generous for a relatively short term and safe baby bond. Although the market seems to be punishing this baby bond simply because HCAP is a smaller cap BDC, the legal leverage limits still apply here which greatly mitigates any risk. Also, insider buying is going on at HCAP. Besides being an excellent buy and hold idea, we also believe that investors more oriented to short term gains will also do well here.
We believe that in a zero interest rate world, locking in safe high yields, while they still exist, is the smartest thing that investors can do right now. It would not be surprising if one year from now we find ourselves in an environment of 5% yields on BDC baby bonds and other safe preferred stocks.
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Disclosure: I am/we are long MVCD, HCAPZ. 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.