MPV - Barings Corporate Investors: 'The Real Deal' Top Income Fund For Over 50 Years

2023-06-14 13:17:05 ET

Summary

• What is in Barings Corporate Investors's "special sauce" that has made it the #1 high-yield bond fund for years, with total returns that even beat the S&P 500?
• One key ingredient is MCI's close relationship with private equity sponsors, and its access to lucrative private credit deals that have boosted annual total returns to 12% over 50 years.
• Having started operations before there was a High-Yield bond market, MCI has been doing "private credit" for decades, long before the mainstream investment media discovered it.
• Recent articles have questioned MCI's valuation methodology because it has to rely on models and other non-mark-to-market techniques to establish its portfolio values.
• A careful reading of its reports and an understanding of its business model and history should allay any investor concerns.

[This article was first published on June 10th for our Inside the Income Factory® subscribers.]

MCI: Double-Digit Returns For 50+ Years

Barings Corporate Investors ( MCI ) has been a top closed-end fund ("CEF") since its inception in 1971, with an annualized return of 12.3% on its net asset value "NAV") over that period, and 11.8% on its market price.

This beats the S&P 500 (SP500), whose annualized return over the past 50 years is 10.5%. This has gained MCI the #1 out of 25 position, for high-yield bond fund total return over the past 10 years (per CEF Data ), as well as #1 out of 26 for 5 years, and #1 of 28 for 3 years. In each of those three periods, the #2 position was held by MCI's sibling fund, Barings Participation Investors ( MPV ); MPV has the same portfolio management team and a very similar investment strategy; its annualized total return of 11.2% on its NAV, and 10.2% on its market price, over its 35-year life, is not too shabby either.

Despite its superior performance over the years, MCI has operated somewhat under the radar scope, with the first article about it on Seeking Alpha in 2017, and only seven more since then.

One of those was my article in June, 2021, when I first wrote about it publicly, having introduced MCI to my Inside the Income Factory members two months earlier. Since, then it has continued to deliver solid performance, and I have added it to our Income Factory model portfolio, and bought a considerable amount of both MCI and MPV into my personal portfolio as well.

Not Your Typical High-Yield Bond Fund

Although listed as a "high yield bond fund" by both CEFConnect and CEFData, MCI differs in a number of key respects from the typical high yield bond fund. To understand the difference, one must appreciate the fact that when MCI was started, back in 1971, there was no high yield bond market.

MCI was originally called "MassMutual Corporate Investors," and invested in privately-placed debt generated by Mass Mutual Insurance Company. The "private placement" market was a well-established credit market that involved dozens of major insurance companies as lenders, of which Mass Mutual was (and still is) a major one. Prior to the 1980s, it was virtually the only way companies rated below-investment grade (i.e., NOT rated AAA through BBB-) could borrow long term, since the public bond markets were only open to investment grade companies.

Commercial bankers, whose own lending was limited to short-term loans and "term loans" that maxed out at 5 years, would often refer corporate clients seeking longer-term funding to insurance companies with whom the banker had a relationship. The insurance company would then negotiate with the borrower and privately place a longer term loan (aka "note" or "bond") with itself and often a larger group of insurance companies and other institutional investors. That was how the "private placement" market was born, and it became the primary means for large non-investment grade companies, as well as middle-market and smaller companies, to routinely issue longer term debt, until the mid-1980s.

The advent of Drexel Burnham, Michael Milken and the high-yield (aka "junk bond") market provided a public alternative for the previously all privately placed debt of the larger non-investment grade companies. These deals, many of which are huge public high-yield bonds, are now routinely underwritten and distributed by large Wall Street investment banks just like investment grade issues.

But privately placed debt for middle market and smaller companies is still a significant business. It includes the sort of loans, notes and bonds traditionally placed with insurance companies and other institutional investors, as well as credit extended by the Business Development Company ("BDC") industry.

Business As Usual (Why Change What Works?)

For MCI and MPV, this is the "privately placed, below-investment grade, long-term debt" business (as they describe it on their websites) that they have long been involved in; essentially the corporate private placement industry, but now referred to generally as "private credit."

MCI's website goes on to say that these privately placed investments have an additional advantage; that they are " often accompanied by equity features , purchased directly from their issuers and sourced through Barings' extensive deal network of private equity sponsors ."

Both MCI and MPV rely on Barings' North American Private Finance ("NAPF") platform, which according to both funds' 1st quarter 2023 reports, "employed more than 60 professionals and had commitments of over $25 billion to private credit," to do all the credit sourcing, due diligence, and portfolio maintenance for both funds. And NAPF apparently does it very well, since MCI's 1st quarter 2023 report says it (i.e., NABF) has had an annual credit loss rate of only 0.04% since its inception, which was about 13 years ago.

A big change in the private credit market from 50 years ago is that back then the referral of corporate borrowers was largely through commercial banks. Today it is generally through private equity firms (aka "sponsors"), who actually own or control most or all of the companies they introduce to private lenders, like Barings and its affiliates. We see this in the breakdown of MCI's portfolio, below, where about 96% of its assets are either privately placed loans and other private debt, or private equity. Here is the breakdown of MCI's portfolio:

MCI tells us in its 3/31/2023 quarterly report that all of its private investments are directly originated by "Barings via a sponsor (without a financial intermediary), where one hundred percent of the economics are passed through to investors."

First of all, that means there is no investment bank in the middle taking an underwriting fee. But a close relationship with the sponsor/owner of your borrowers has additional advantages that a typical passive high-yield bond investor does not have, in terms of closer ongoing relations with your borrower and, in particular, being in control of any re-negotiations or "loan workout" activity, should that become necessary. Also unlike high-yield bond investors, 65% of MCI's portfolio consists of first-lien senior secured loans, which are at the top of the liability structure, and get paid first in the event of any problems.

Beyond the "defensive" advantages (1st lien security, closeness to the sponsors, etc.) MCI's business model also includes the ability, in many of its deals, to obtain potential upside in the form of equity warrants or conversion rights of some sort. The accumulated benefit of that shows up in the almost 13% of MCI's portfolio that consists of private equity, which provides MCI with potential capital gains over and above the steady Net Investment Income ("NII") that supports its regular distributions.

We see that in the past 5 years results, the fund's NII generally supports the current distribution, but occasionally when the NII comes up short, the accumulated capital gains from the equity portfolio have more than covered it. For the recent quarter, the fund had extraordinarily high NII of $0.43 per share, compared to $0.29 in the 4th quarter of 2022. It had an additional 5 cents per share in capital appreciation during the quarter. The NII increase was due to the higher interest rates on its floating rate loans, as well as its collection of past interest on a loan that had previously been on non-accrual. As a result, the fund was able to increase, and easily cover, its dividend, which is now $0.32 per quarter, up from the previous $0.28. (The dividend doesn't show in these figures because it was declared and paid after the end of the quarter.)

As we have discussed in previous articles , Net Investment Income ("NII") is the "business as usual income" for most credit or other income-oriented funds. It represents the interest and dividends that a fund collects, minus its operating expenses; and, therefore, represents the routine cashflow that a fund can expect its portfolio to produce on a regular basis, irrespective of whatever "paper" profits or losses the fund may have as it marks-to-market or otherwise estimates the current value of its assets.

MCI's "business as usual" income is mostly the interest from its loan and bond portfolio, as well as the dividends from its private equity portfolio. The capital gains from that equity portfolio, as well as from whatever other warrants or equity features it negotiates for itself, are more volatile, but still extremely important as the above numbers indicate. I think it is those capital gains over time, along with perhaps better credit performance from Barings' overall sourcing, origination, and credit underwriting generally, that may account for MCI and its sibling MPV's consistently superior performance over many years, compared to more garden variety high-yield funds.

The rise in MCI's Net Asset Value ("NAV") from 2018 to the present, from $15.22 to the 3/31/2023 figure of $16.85, shows how MCI has managed to more than cover its increasing distribution, largely from its NII with occasional help from its capital gains, while still growing its shareholders' capital value.

Valuing A "Private" Portfolio

Determining the Net Asset Value of a portfolio of privately placed assets that don't trade and are not marked-to-market anywhere, is challenging. But it is done all the time in the private equity world where firms invest in, buy, and sell private businesses without any market prices to rely on. But they use numerous models, algorithms, rules-of-thumb, discount formulas and other tools to come up with valuations on which billion dollar transactions are then based.

MCI uses similar techniques to value its portfolio of both debt and equity instruments. In its financial reports its outlines the various methodologies it uses in valuing its private, non-traded securities (which are the great majority of them). In general, it uses what's called an "income approach" for its debt holdings, which is essentially a traditional discounting of the projected future cash flows of an instrument. Of course, the key variable is the discount rate, which would have to incorporate a range of other variables, including the base interest rate level, an appropriate credit spread to reflect the credit rating and/or risk of the specific borrower, and other features (collateral, structure, etc.) of a particular deal. For its equity holdings, it uses other techniques, which generally involve first estimating the overall enterprise value and then using a waterfall approach to distribute that value to various stakeholders (senior and subordinated creditors, preferred stockholders, etc.) with the residual being the equity value.

In other words, a lot of judgment calls. We as shareholders, can read the reports and all the footnotes, but still are left with the question of whether we trust MCI's management, based on its record, as well as the fund's governance structure - board of directors, auditors - to make good decisions and do the right thing. Personally, as an investor and shareholder, I have no concerns and, indeed, regard MCI as a class act.

MCI is quite transparent about listing all its holdings, providing a brief description of the security, its original cost and acquisition date, and its current estimated value . However, a recent article here on Seeking Alpha, while generally positive about the fund, raised a question about its valuation methodology, using one particular investment as its example.

The holding the article questioned was "Specified Air Solutions," a maker of heating, dehumidification and air quality products. MCI first made a loan to Specified back in 2018 and then the following year acquired some units (i.e., equity) in it as well. Being curious about the transaction, I Google-searched the company and see that a couple months before MCI acquired its investment in Specified, the company was sold by the Sterling Group (a private equity group) to Madison Industries Indoor Air Quality group.

On its face, this looks like a typical MCI deal, involving a middle market company being spun off by a private equity firm with MCI participating in the financing. The Seeking Alpha article focused on the valuation change from September 30, 2022 to the yearend 2022 valuation, which increased from $20.5 million in September to $21.5 million three months later. The author of the article contended that increasing the valuation made no sense, because Specified Air Solutions' parent, Madison Indoor Air Quality, had just had its credit ratings reduced slightly the previous quarter, from the equivalent of a single-B to a single-B-minus. Based on that downgrade, and the assumption that Specified Air Solutions' parent was now apparently a worse credit than previously, and therefore Specified Air Solutions itself must have been a worse credit as well, the author said he/she no longer had confidence in the accuracy of MCI's NAV estimates, so they recommended passing on the fund.

While I can understand the author's reasoning, I think their conclusion is somewhat draconian given the history and record of the fund and its management. I was happy to see that most commenters on the article seemed to agree with me on that. An important detail that may have been ignored in the article was that by the end of 2021, MCI's Specified/Madison investment was no longer a loan, but was solely an equity investment . It had been paid off and was fully converted to equity. That would make a credit rating downgrade of its parent company less relevant, as the model for evaluating its equity value would utilize different factors and other variables than the model for evaluating loans and similar debt obligations.

"Junk" Need Not Be Junky

In addition, it is important to realize that a credit downgrade from single-B to single-B-minus, while it does reflect an increased level of credit risk, is not all that unusual or any sort of harbinger of doom for a non-investment grade company (and the majority of ALL companies are non-investment grade companies.)

For example, KKR Income Opportunities Fund ( KIO ), which has the best record of all high yield bond funds so far in 2023 ( per CEFData) , lists 42% of its portfolio of high yield loans and bonds in the triple-C category, below the single-B-minus level that Specified/Madison inhabits. Collateral security makes a big difference, as well, which is why rating agencies typically apply separate ratings to both the issuer and the specific debt issue. For example, a corporate issuer might be rated single-B as a stand-alone, unsecured credit, but a specific well-secured loan to that company or one of its subsidiaries (like MCI's to Specified, or the 44% of KIO's assets that are senior loans) may be rated a notch or two higher because of the deal's security and structure. This "notching up" of an issuer's "corporate credit" rating to reflect the enhanced protection afforded by collateral and other structural features was a significant change in rating corporate debt that began back in the 1990s , at the time commercial banks had begun to distribute many of the loans they originated to third party institutional investors.

But there is even more to the Specified/Madison story than just the relatively small change in the investment's value during the last quarter of 2022. If we go back to when MCI first acquired its interest in Specified, between 2018 and 2020, we see that its total acquisition cost, for both the debt and the equity units, was $4.7 million, but by the end of 2021, its estimated value was up to $22.9 million. During 2022, as interest rates changed along with other inputs into Barings valuation models, the value varied between $19 and $21 million, most recently settling at $21.3 million on March 31.

So the real story here isn't the small change in value from one quarter to the next in 2022; but rather the jump in value from $4.7 million to $21 million, over a 3 year period. In other words, this deal was a home run; and while we don't expect MCI to be this successful on all or most of its investments, its ability to do it once in a while by being active and well-plugged in to the private equity markets, is that extra "special sauce" that differentiates MCI from your average high-yield bond fund.

Bottom Line

Barings Corporate Investors has shown excellent results over many years, although it is clear that the market has not fully appreciated its fine record, at least recently where its market price had dropped to a double-digit discount. This is not too surprising when you look at how credit funds in general (senior loan, high yield bond, etc.) have been heavily discounted in recent months, because of the generalized fear of credit default and loss in anticipation of a recession or downturn that has gripped the credit markets for the past year. [NOTE: MPV, MCI's sibling fund, while somewhat smaller, is currently selling at an even bigger discount, about -14% versus MCI's -10%, so investors might consider it even more of a bargain, considering its similar portfolio, investment style, distribution yield and recent earnings performance.]

Our current financial and economic environment is clearly not without risk. But I believe MCI and the credit gurus at Barings have fully considered the potential for an economic downturn or recession and incorporated it into their credit analysis and due diligence, as they have in decades past. As we have discussed in previous articles, the media tends to hype fears of economic turbulence and other negatives, but the reality is often less scary than what was predicted. Headline "default predictions" especially, tend to greatly overstate the actual "losses" that well secured lenders end up suffering, once typical recoveries of 70% or so of principal on defaulted loans are factored in.

I don't mean to sugar-coat whatever economic and financial problems lie ahead, but as I have written many times over the past year or so, in a volatile economy I would rather invest in credit than equity, where I'm further up the balance sheet and all my issuers have to do is stay alive and pay their debts, even if their profits drop and stock plummets. As readers know, I call credit investing "betting on horses to merely finish the race," as opposed to equity investing which is more like "betting on horses to win, place or show."

Credit bets are a lot easier to win, which is why so much of my investing recently has been in the credit sector: loan funds, high yield bond funds, BDCs. A well-diversified portfolio, with Barings Corporate Investors at the top of the list.

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