Kobus Louw
Today, many investors are looking for very high-yielding stocks and bonds. Ultra-high-yield investments are prevalent today due to the growing number of retired individual investors. Over the past decade, there has been a solid trend toward high stock ownership among older Americans as the traditional conservative retirement investing strategies are undone. On the one hand, this approach increases monthly income and overall returns. However, investors, particularly those looking to maintain their capital over a long time horizon, should understand the risks in many high-divided equities.
In my view, option “income” ETFs and Business Development Companies are two areas where I believe many investors inappropriately discount risks due to the allure of double-digit dividend yields. For the most part, these investments experience lower volatility on a month-to-month basis and pay excellent yields, creating the perception of low risk. However, in the event of certain market conditions, these strategies can face sudden and potentially permanent catastrophic losses. That is particularly true for BDCs following regulatory changes that allowed them to boost their leverage levels.
One of the more popular BDCs is PennantPark Floating Rate Capital (NYSE:PFLT). PFLT pays a 10.75% yield today, making it a popular choice among income-focused investors. The BDC has had solid returns over the past five years, delivering a total return of just over 50%. Its overall performance is slightly below that of the VanEck BDC Income ETF (BIZD) at 76%. However, the gap is primarily driven by the event divergence between the two. See below:
On the one hand, investors may see its solid performance, high dividend, and quick recovery in 2020 as a sign that it is a Goldilocks income investment. However, that does not change the fact that it had lost well over 50% of its value in just a few weeks in 2020. Further, if it was not for tremendous efforts by the US Treasury and Federal Reserve to stimulate the economy, it is unclear, and in my opinion unlikely, that such a recovery would have occurred. Of course, the BDC’s approach has shifted in recent years, so closer inspection is necessary to gauge its risk-reward profile.
PFLT Maximum Reasonable Downside Estimate
Business Development Companies generally fall into the category I call “up like an escalator, down like an elevator” investments. This is typical among most that pay double-digit yields. High yields are sustained, delivering a somewhat constant stream of solid returns; however, the cost is often catastrophic and rapid losses. Due to the combination of non-liquid debt investments and leverage, periods of low market liquidity or potential credit issues can quickly result in capital losses.
However, as seen in 2020, those losses need not be permanent if those companies can maintain credit stability. In 2020, that was mainly due to the doubling of the money stock that year, matched with immense business stimulus efforts and massive interest rate reductions. Thus, it should not be assumed that the government can repeat such a widespread bailout program. Of course, in 2020, this was exceptionally reasonable because the government also deliberately caused a recession (in that the recession should not have occurred without lockdowns), warranting stimulus.
Still, investors must account for the natural rate of declines in PFLT due to credit losses. Over the past decade, its tangible book value per share has fallen by over 23%, or at a rate of about 2.6% per year, with some degree of consistency. Its price is usually very close to its tangible book value, but it trades at a slight premium of about 2.7%. See below:
From this standpoint, PFLT is slightly overvalued today. Over the past decade, its price-to-tangible book value has fallen around 0.96X, making it theoretically overvalued by around 7% on a historical basis. That figure is not too alarming, but it does imply potentially lackluster returns should the pattern continue. Further, because it is trading at a slight premium, there may be a higher chance that the BDC will sell new equity, potentially lowering its value.
PFLT should theoretically face higher book value losses amid the rise in interest rates because that will make it slightly more difficult for some companies to meet obligations. However, outside of its leverage costs, the rise in interest rates also increases PFLT’s ROI. Still, the company’s EPS and cash flows have not risen dramatically in response to higher rates, likely due to the offset from its falling book value.
The company’s credit risk is not extreme but could become an issue in a recession. At the end of Q3, 85% of its assets were in first-lien senior secured debt, with the rest in preferred and common equity. That type of debt has the best position in the case of default and is backed by secured assets, usually significantly limiting downside risk potential.
The BDC focuses on the middle market, or companies with earnings of $10 to $50M, which are often an excellent lending target because they’re outside the scope of many large banks but outside the “small business” category, which are often securitized. The benefit of this category is it usually has a 1-2% lending premium, creating a naturally higher risk-reward tradeoff. However, the cost is their lack of liquidity, a potentially significant issue in a market crash.
PFLT’s core middle market strategy targets’ usually have 4X to 5.5X leverage, which is material, and pricing of SOFR + 5.5% to 7%, meaning the natural yields may be as high as 12.5% today. High yields make for high returns, but the associated costs may increase default risks, particularly given a recession. As later noted in its last presentation, the average default rate in this loan class is 1.1%, with a 73.8% recovery rate, compared to 7.3% and 40% for high-yield bonds. The yields are higher than most high-yield bonds, indicating a tremendous risk-reward tradeoff. PFLT’s portfolio is diversified across many industries, lowering its risk to one-off industry issues.
The BDC has also lowered its leverage level to 0.79X, or 0.76X, using its non-GAAP measure, a considerable decline YoY. At the same time, its working capital accounts for about 13.6% of its market capitalization, giving it ample liquidity. See below:
One major issue I’ve seen in BDCs is the sharp increase in leverage since the 2019 law that increased their debt-to-equity limit to 2:1 from 1:1. Many BDCs have ramped up leverage to drive higher yields. That was somewhat sensible when interest rates were lower, but today, it is likely unwise because that increases risk while hardly improving returns due to higher borrowing costs. PFLT is now trading back below the old leverage limit and significantly below its late 2019 leverage level. Theoretically, that should limit its downside risk in a recession compared to 2020, though it may be offset by the higher credit risks that naturally occur in high borrowing cost environments.
Due to its lower leverage, I believe PFLT’s downside risk is less significant than in 2019. Further, because interest rates are higher, its potential income is as well. Additionally, compared to most dividend investments, PFLT has attractive qualities by lending to a chronically undervalued credit market segment with low credit risk and very high yields.
The Bottom Line
PFLT has lost about 10% of its value over the past month as it lost its equity premium. That said, it may still have some downside before trading back at its typical price-to-book value level, perhaps 5% to 9%. I would only buy PFLT if it were trading at a discount to its average price-to-book ratio because any premium will encourage equity sales.
Compared to most other BDCs, PFLT is superior due to its focus on floating rates, lower risk, and middle market companies with significant diversification and reduced leverage. That said, just because PFLT is likely lower risk than the typical BDC does not make it low risk. Income-oriented investors focused on capital preservation may still want to limit exposure to PFLT because it may lose 30-40% of its value if market liquidity declines during an equity crash.
As stated in many of my articles over recent months, I believe it is a better time to focus on cash (with its 5% yield) than to allocate toward higher beta assets like PFLT, having a beta around 0.9X (making it nearly as risky as the S&P 500). I believe this risk is exacerbated by the fact that the US government (nor the Federal Reserve) can bail out credit markets again in the event of a market crash, increasing the odds of permanent losses. Therefore, I am neutral on PFLT but have a slight short-term bearish bias.
