SSSSL - Building A Balanced Portfolio With Main Street Capital

2023-09-19 05:30:00 ET

Summary

• This is a series of articles discussing retirement portfolios using BDCs currently yielding around 12% and their safer notes, baby bonds/preferred shares with yield-to-maturities ranging from 6% to 9%.
• We discuss the interest expense and asset coverage ratios for one of the more popular and higher-quality BDCs as well as its investment-grade bond.
• I prefer bonds/notes (with CUSIPS) to the Baby Bonds (with tickers) due to the "make-whole premiums," compensating bondholders for the interest they would have earned if they were called/redeemed early.
• The following table shows some examples of allocations and my personal portfolio (not exact) with portfolio yields ranging from 5.2% to 9.4%.

Introduction

Over the coming months, I will have a series of articles discussing how to build a balanced retirement portfolio using business development companies' ("BDCs") common stocks currently yielding almost 12% and their safer notes - baby bonds/preferred shares with yield-to-maturities ranging from 6.5% to 9.0%. This article discusses Main Street Capital ( MAIN ) currently yielding around 8.3% (including supplemental dividends, discussed later), and its 2026 bond/note (CUSIP: 56035LAE4) with a yield-to-maturity of around 7.5%.

MAIN is for lower-risk investors with the ability to leverage its internally managed cost structure and 99% of its debt investments in first-lien positions. Also, MAIN has an excellent history of NAV per share growth with lower amounts of non-accrual investments and an excellent balance sheet including lower-cost flexible unsecured borrowings.

Business development companies invest shareholder capital in privately-owned, small- and medium-sized U.S. companies generating income from secured loans and capital gains from equity positions, much like venture capital or private equity funds.

The BDCs in the chart below account for around 90% of the total assets and market capitalization for the sector. Over three months, we discussed the portfolio credit quality and/or dividend coverage for most of them, including Ares Capital ( ARCC ), FS KKR Capital ( FSK ), Blue Owl Capital ( OBDC ), Blackstone Secured Lending ( BXSL ), Prospect Capital ( PSEC ), Golub Capital BDC ( GBDC ), Goldman Sachs BDC ( GSBD ), Oaktree Specialty Lending ( OCSL ), New Mountain Finance ( NMFC ), Hercules Capital ( HTGC ), Sixth Street Specialty Lending ( TSLX ), PennantPark Floating Rate Capital ( PFLT ), PennantPark Investment ( PNNT ), BlackRock TCP Capital ( TCPC ), Gladstone Investment ( GAIN ), Gladstone Capital ( GLAD ), Monroe Capital ( MRCC ), Trinity Capital ( TRIN ), and TriplePoint Venture Growth ( TPVG ) in the following articles:

• ARCC: Assessing The Recent Results For 10% Yield
• Building A Balanced Portfolio With BXSL
• PSEC: Still Arranging The Deck Chairs
• Better High-Yield Buy: FSK or PSEC?
• Solid 10% Yield From OBDC or TSLX?
• Lower Fees Driving Higher Dividends: GBDC
• Safer 12% Yield: GSBD or MRCC
• Solid 10% Yield From GAIN & GLAD
• OCSL or NMFC For Solid 11% Yield?
• PNNT: Big Win From Dominion/Fox Settlement
• Venture Debt Opportunity Yielding 13% To 14%: HTGC or TPVG?
• TCPC or PFLT For Solid 12% Yield?
• TRIN: Initiating Coverage Of This 14% Yielding BDC

Many readers ask where BDC stocks and bonds fit into their overall portfolio. Your portfolio allocations depend on a few factors, including your age, overall risk appetite, investment time frame, and need to access capital.

BDCs are for longer-term investors so please allow an investment time frame of at least three years. The following charts use the oversimplified asset classes of cash, treasuries, corporate bonds/notes, other stocks (general market equities), and higher-yield investments (including BDCs) along with some examples of allocations and my personal portfolio (not exact):

The table below uses what I consider to be conservative estimates for annual total returns (dividends plus capital gains) and takes into account current price levels.

Most BDCs typically do not directly invest in travel, entertainment, retail, restaurants, sporting event-related businesses, airlines, oil/energy, etc., and if they do it's a small portion of the portfolio. MAIN has a highly diversified portfolio of 211 portfolio companies across many industry segments:

Nine investments remain on non-accrual status, at around 0.3% (previously 0.6%) of the investment portfolio at fair value and 1.7% at cost (previously 3.2%). I will discuss some of these investments in a follow-up article focused on credit quality.

As shown below, MAIN continues to focus on its Lower Middle Market ("LMM") portion of the portfolio with higher yields currently almost 13%.

We are very pleased with our quarterly results, which included continued positive results from our lower middle market and private loan investment strategies and significant contributions from our asset management business. Our performance was highlighted by a return on equity of 19% and new quarterly records for net investment income per share, distributable net investment income per share and net asset value per share for the fourth consecutive quarter. The continued strong performance of our LMM portfolio companies was highlighted by the second consecutive quarter with a new record level of dividend income from our portfolio equity investments. We believe that these results demonstrate the continued and sustainable strength of our overall platform, the benefits of our differentiated and diversified investment strategies, the unique contributions of our asset management business and the underlying strength and quality of our portfolio companies. We are also pleased with the level of investment activity in the quarter in both our LMM and private loan portfolios and the healthy pipeline of investment opportunities in these investment strategies. This attractive investment pipeline, together with our conservative liquidity position and capital structure, provides us a continued favorable outlook for the third quarter.”

MAIN Dividend and Coverage Ratios

MAIN has excellent dividend coverage with the potential for additional dividend increases and/or supplemental dividends, mostly due to continued improvement in net interest margins as well as NAV per share increases and realized gains. As mentioned in previous articles, I'm expecting additional dividend increases over the coming quarters due to:

• Higher portfolio yield due to wider investment spreads and higher rates.
• Portfolio growth (increased interest income).
• Higher returns from its asset management business (MSC Income Fund).
• Continued dividend income from portfolio companies.

MAIN recently announced an increase of its regular monthly dividend from $0.230 to $0.235 per share for Q4 2023 plus another supplemental dividend of $0.275 per share for Q3 2023.

Our distributable net investment income in the second quarter exceeded the monthly dividends paid to our shareholders by 66% and the total dividends paid to our shareholders by 24%. This strong performance allowed us to deliver significant value to our shareholders, while still conservatively retaining a meaningful portion of our income and growing our net asset value per share. In addition, our strong second quarter results and favorable outlook for the third quarter resulted in the declaration of an increase to our monthly dividends for the fourth quarter of 2023 and a $0.275 per share supplemental dividend to be paid in September 2023. This September 2023 supplemental dividend represents our largest and eighth consecutive quarterly supplemental dividend, along with five increases to our regular monthly dividends over the same period, and results in a 30% increase in the total dividends paid in the third quarter of 2023 and a 24% increase in the total dividends paid year to date through Sept. 30, in both cases when compared to the prior year.

The “Interest Expense Coverage” ratio is used to see how well a company can pay the interest on outstanding debt. Also called the times-interest-earned ratio, this ratio is used by creditors and prospective lenders to assess the risk of lending capital to a firm. A higher coverage ratio is better, although the ideal ratio may vary by industry. When a company's interest coverage ratio is only 1.5 times or lower, its ability to meet interest expenses may be questionable.

The “Asset Coverage Ratio” is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets. The higher the asset coverage ratio, the more times a company can cover its debt. Therefore, a company with a high asset coverage ratio is considered less risky than a company with a low asset coverage ratio. BDCs are required to maintain minimum asset coverage of 150% providing strong protection to bondholders, which is one of the reasons that no publicly-traded BDC has ever filed for bankruptcy nor defaulted on bondholders in the history of the sector.

The following table shows the historical coverage ratios for MAIN:

MAIN Investment-Grade Bond/Note

I like BDC bonds partially due to their quality and relatively shorter-term maturities, providing reduced price volatility during market drawdowns, and outperforming other higher-yield assets during market sell-offs. Most BDC bonds mature over the next three to five years which is excellent for investors given the current inverted yield curve (short-term rates higher than longer-term).

I prefer the bonds/notes (with CUSIPS) to the Baby Bonds (with tickers), mostly related to the "make-whole premiums," which compensate bondholders for the interest they would have earned if their bonds had not been called, or redeemed, by the issuer before the maturity date to ensure that bondholders are receiving fair compensation for the loss of the bond's future coupon payments. BDC bonds are attractive for many reasons including having higher yields/returns than other investment-grade bonds combined with the capital protections provided by the unique structure of BDCs. Also, given my focus on the risk and quality of BDC common shares, I have an intimate understanding of the risk and quality for bondholders. The following are some options that management teams have before potentially defaulting on a debt obligation:

• Reducing leverage by not reinvesting repayments from portfolio companies
• Reducing the dividend to common shareholders
• Reducing or waiving management and incentive fees
• BDCs have permanent equity capital (no "runs on the bank" to force the liquidation of undervalued assets)
• Raising equity capital: common or preferred, even dilutive if absolutely necessary
• External manager/credit platform can provide additional capital if needed

For these reasons, no BDC has defaulted on a debt obligation.

As shown below, the yield-to-maturity (“YTM”) for MAIN’s 20026 bond has recently increased to around 7.5% :

Upcoming Articles

This article discussed MAIN which is considered a safer BDC with a current yield of 8.3% for its common stock and 7.5% for its note due 2026. Both should be considered for a balanced portfolio.

Stock market volatility will likely remain elevated, and BDC bonds allow investors to lock in 6% to 9% annualized returns with maturities ranging from one to eight years. Please note that locking in a much safer return is attractive, especially considering the potential for "reinvestment risk" of investing in treasuries/money market funds (if rates go back down eventually).

As mentioned earlier, I will have a series of articles discussing how to build a balanced retirement portfolio using BDC stocks and their safer bonds/notes. The following table shows some examples of allocations and my personal portfolio (again, not exact) with portfolio yields ranging from 5.2% to 9.4%.

Many other BDCs have tradable Notes, Baby Bonds, and Preferreds including ARCC , BXSL , CCAP , CSWC , FDUS , FSK , GAIN , GBDC , GECC , GLAD , GSBD , HRZN , HTGC , NMFC , MFIC , OBDC , OCSL , OFS , OXSQ , PFLT , PNNT , PSEC , RWAY , SAR , SSSS , TCPC , TRIN , TSLX , and WHF . Many of these BDCs have recently issued new bonds/notes providing much higher effective yields earning over 7% to 8% annual cash distributions (paid quarterly) which are much higher than the previous effective yields of 5% to 6%. Each of these bonds has recently been added to the BDC Google Sheets .

For further details see: