CGBD - A Look At The New 8%+ Yielding BDC Baby Bonds

2023-12-21 07:58:19 ET

Summary

• The Fed's pivot towards rate cuts raises concerns about the performance of floating-rate assets and suggests a move along the yield curve.
• BDC baby bonds are attractive assets due to their decent quality, fixed coupons and relatively low durations.
• We highlight a number of newly issued bonds by BDCs.
• Drier-powder assets like BDC baby bonds can reduce volatility, protect against drawdowns, and potentially outperform higher-yield assets during market sell-offs.

It's fair to say that the most important development across markets is the Fed's pivot. Now that the Fed is telling the market to expect 7 rate cuts over the next two years it begs the question whether it's time for investors to exit floating-rate assets and move out along the yield curve.

The answer seems obvious - if short-term rates fall, so will the income generated by these securities. Not only is this unwelcome in itself it also means that these securities are unlikely to remain in favor and could see some selling pressure, perhaps even driving prices lower as well as pushing discounts wider for closed-end securities like CEFs and BDCs that allocate to floating-rate assets.

It might seem obvious to reallocate to longer-duration securities to lock in today's yield for as long a time as possible. However one problem with this view is that the market has not exactly stood still - 10Y Treasury yields are lower by more than 1% from their recent peak and stand 1.5% below short-term rates.

In short, the yield curve is pricing in hefty cuts over the following few years so investors who move out along the yield curve today have to settle for significantly lower yields.

This re-inversion of the yield curve means there is less margin of safety in longer-duration securities. The key risk to moving out the yield curve is the scenario that disinflation proves harder than expected and the Fed sticks with the current policy rate for longer or even hikes one more time.

So rather than maxing out duration what can make more sense is a moderate extension towards the belly of the yield curve (closer to the 2-5Y maturity point) where the potential in reversal in rates would be less painful. This is where BDC baby bonds can come in handy.

We have recently seen a significant uptick in issuance of BDC baby bonds and in this article 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.

Why BDC Baby Bonds

Outside of their duration position in the belly of the yield curve (i.e. not too long, not too short - a feature which mitigates price volatility), 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 sweetspot 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, an inverted yield curve means 3-5Y bonds (the sweetspot in BDC baby bonds) will offer higher yields than 10Y+ bonds, all else equal. And, being fixed-rate securities, their dividends will remain fixed if the Fed starts to take the policy rate lower.

Finally, 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.

Roundup Of Recent Issuance

Over the last few months, we have seen bond issuance from the following BDCs:

• WhiteHorse Finance - issuer of the 7.875% 2028 bond (WHFCL)
• Carlyle Secured Lending - issuer of the 8.2% 2028 bond (CGBDL)
• New Mountain Finance Corp - issuer of the 8.25% 2028 bond (NMFCZ)

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

• NAV stability / resilience - a stable and resilient NAV over time is indicative of a quality underwriting process. Debt investors are much more interested in the downside risk of the BDC portfolio rather than the upside, so a stable NAV can protect debt investors over time
• Leverage - a lower level of leverage is more attractive, all else equal, as it indicates a higher amount of equity supporting each dollar of debt
• Position of unsecured debt in the capital stack - the less secured debt (e.g. credit facilities) there is ahead of the debt the better as more of the assets will be left over to cover the bonds after paying off secured debt
• Portfolio composition - portfolios with a greater allocation to first-lien loans (versus second-lien or subordinated debt) are preferrable, all else equal.

Given these metrics, we see value in both WHFCL as well as CGBDL, trading at 8.05% and 7.45% yields. CGBD NAV is not miles off its peak over the last few years while the WHF NAV is around 3% lower than it was 5 years ago.

Both portfolios are allocated primarily to first-lien loans - at around 80% for both companies, slightly above the average in our coverage. This number is understated for WHF as it does not include the 15% allocation to its joint venture portfolio.

Leverage is around the sector average at 1.16x (net leverage) for WHF and 1.06x for GGBD.

As far as the position of unsecured debt in the liability stack, WHF has a credit facility which comprises about half of its total liabilities - fairly typical of the BDCs in our coverage. The credit facility is secured debt and stands ahead of unsecured bonds. This means that from a bondholder perspective the smaller the credit facility footprint the better. CGBD is somewhat ahead on this front - the credit facility makes up only about a third of total debt.

Of the new bonds, CGBDL and WHFCL look most attractive to us. They are trading at yields around 8.05% and 7.45% respectively - these are not the highest yields on offer in the sector however they do offer the best risk/reward in our view.

For further details see: