CCAP - REITs Or BDCs For Your Retirement Portfolio?

2023-09-27 15:39:44 ET

Summary

• This article compares the returns for two of the higher yield sectors - real estate investment trusts (REITs) and business development companies (BDCs).
• BDCs have easily outperformed REITs over the short and long term, as discussed below, along with where BDC stocks and bonds fit into your portfolio.
• For the same income with less risk, it's better to invest 50% less capital in BDC stocks at 11.5% and BDC bonds at 7.5% compared to equity REITs at 5.3%.
• BDCs have been deleveraging, previously reduced fixed borrowing rates, shifting portfolios into secured assets in non-cyclical sectors with stronger covenants, and improving net interest margins.
• These changes have resulted in much stronger balance sheets ready for anything from an economic recession to an overheated economy driving inflation and higher rates.

As discussed in " This High-Yield Sector Continues To Pummel REITs " and " REITs Continue To Underperform BDCs ," business development companies ("BDCs") have easily outperformed real estate investment trusts ("REITs") over the short and long term for many reasons including:

• Continued strong credit performance (for most).
• Maintaining NAV per share.
• Previous and continued shift into true secured first-lien assets with stronger covenants.
• Better positioned for changes in interest rates.
• Previously issued unsecured borrowings at very low rates.
• Average dividend coverage of 131% for the most recent quarter (even after taking into account increased dividends).
• Lowering overall leverage with plenty of growth capital to take advantage of a much more "lender-friendly environment" with "higher overall yields," better terms, and stronger covenants (safer investments).
• Continued to focus new investments in non-cyclical sectors.

Similar to REITs, Business Development Companies are regulated investment companies ("RICs") required to pay at least 90% of their annual taxable income to shareholders, avoiding corporate income taxes before distributing to shareholders. This structure prioritizes income to shareholders (over capital appreciation), driving higher annual dividend yields currently ranging from 9% to 15% (shown in the table below). I firmly believe that higher-yield investments will remain attractive in an inflationary environment as investors seek additional income from their invested capital.

Typical Steps to Creating a Retirement Portfolio

A typical advisor charges 1% or more of the portfolio value per year for what most people can do themselves.

1. Set a realistic budget.
2. Calculate the amount of pre-tax income needed from your investment portfolio.
3. Assess risk tolerance including asset allocations .

Many subscribers 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. Historically, investment advisors used the "100 minus your age" axiom to estimate the stock portion of your portfolio. However, that was likely when the average life expectancy was 65 to 70 compared to the current 85 or higher depending on many factors , and has been revised to 120.

• For example, if you're 60, 60% of your portfolio should be in stocks.

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/CEFs/REITs) along with some examples of allocations and my personal portfolio (not exact):

Hopefully, investors have been reading our series of articles over the last few weeks discussing how to build retirement portfolios using BDC common stocks currently yielding around 11.5% and their safer bonds/notes with yield-to-maturities ranging from 6% to 9%. For my personal portfolio, the "Corp. Bonds" of 37% is primarily with BDCs which will be discussed in upcoming articles. Many BDCs have tradable Notes, Baby Bonds, and Preferreds including Ares (ARCC), Blackstone Secured Lending (BXSL), Crescent Capital BDC ( CCAP ), Capital Southwest ( CSWC ), Fidus ( FDUS ), FS KKR ( FSK ), Gladstone Investment ( GAIN ), Golub Capital ( GBDC ), Great Elm ( GECC ), Gladstone Capital ( GLAD ), Goldman Sachs BDC ( GSBD ), Horizon ( HRZN ), Hercules Capital ( HTGC ), Main Street ( MAIN ), MidCap Financial Investment ( MFIC ), New Mountain Finance ( NMFC ), Blue Owl Capital ( OBDC ), Oaktree Specialty Lending ( OCSL ), OFS Capital ( OFS ), Oxford Square Capital ( OXSQ ), Pennant Park Floating Rate Capital ( PFLT ), Pennant Park Investment ( PNNT ), Prospect Capital ( PSEC ), Runway Growth Finance ( RWAY ), Saratoga Investment ( SAR ), SuRo Capital ( SSSS ), BlackRock TCP Capital ( TCPC ), Trinity Capital ( TRIN ), Sixth Street Specialty Lending ( TSLX ), and WhiteHorse Finance ( WHF ). Some of these 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 .

Comparison of BDC and REIT Returns

As mentioned (and shown) in the articles linked above, BDCs have easily outperformed REITs over the short and long term. It should be noted that the BDC sector is relatively new and many of the best BDCs have not been publicly traded for longer than 10 to 15 years.

The following tables show the updated total returns over the last five years including the WF BDC Index ETN ( BDCZ ) which continually underperforms the average for the reasons discussed in " ETFs Are The Worst Way to Invest In This High-Yield Sector ."

I do cover some of the lower return BDCs including MRCC and MFIC to help identify what to look out for in the others as well as establishing a range for target prices. Also, there's a chance that these BDCs could be upgraded providing higher returns than the others.

The following tables assume that you purchased each position at the close of Dec. 31, 2019, and sold at the close of Sept. 20, 2023, collecting (not reinvesting) the dividends (including paid, accrued, specials, and supplementals).

The "Other BDCs" include many of the lower-performing companies that I do not actively cover including SLRC , BBDC , BKCC , PFX , OXSQ , and LRFC . It should be noted that all of these BDCs are well over 20% below their 2019 stock price levels (except BBDC and PFX) similar to TPVG which I sold last year for the reasons discussed in previous articles (linked below). Also, many of the lower-performing BDCs previously cut their dividends.

• Please see the end of this article for my takeaways from these tables.

The top performers were predicted/discussed in recent and previous articles including:

• FDUS: My Top Pick For The High-Yield BDC Sector In 2022 .
• OCSL or NMFC For Solid 11% Yield? .
• Venture Debt Opportunity Yielding 13% To 14%: HTGC or TPVG? .
• Why I Bought CGBD Currently Yielding 21% .
• CSWC: Stock Or Bonds For Your Retirement Portfolio? .
• ARCC: Assessing The Recent Results For 10% Yield .
• TSLX: Buy This Inflation Resistant Dividend Monster .
• PNNT: Big Win From Dominion/Fox Settlement .
• Solid 10% Yield From GAIN and GLAD .

Some of the underperformers were discussed in previous articles:

• FSK: 14% Stock Yield Or 8% Bond Yield?
• TCPC or PFLT For Solid 12% Yield?
• Why I Trimmed My Position In MAIN (from August 4, 2020).
• MFIC: Apollo's 11% Yield And 20% Discount To Book .
• SLRC: Vote 'No' On This High-Yield Merger .

One of the many reasons that I like to invest in the BDC sector is taking advantage of market volatility to lower my weighted average purchase prices, driving much higher returns. Investors who continue to take advantage of risk-off market events have easily outperformed the returns shown in the previous tables. I continue to build my smaller positions during most of the recent pullbacks (including March 2023, September 2022, and June 2022) which will be discussed in upcoming articles for each BDC.

The following tables show the updated comparable REIT returns for some of the popular companies discussed on Seeking Alpha along with the Vanguard Real Estate Index Fund ( VNQ ) which has outperformed many/most equity REITs and the Mortgage REIT Index ( REM ).

I simply use VNQ for my REIT allocation which has easily outperformed many of the popular and/or larger REITs, but sold in late 2021.

As mentioned in previous articles, I simply use VNQ for my REIT allocation which has easily outperformed many of the popular and/or larger REITs including AMT , SUI , CCI , ELS , ESS , AVB , WPC , FCPT , NNN , EQR , MPW , WELL , SPG , O , VTR , DLR , and STOR . At this point, it seems like trying to catch a falling knife especially some of the ones trading at or near their four to five-year lows including CCI, MPW (cut its dividend), AMT, ESS, and SUI. I will likely repurchase VNQ next year.

Why do BDCs Continue to Outperform?

BDCs typically pay much higher dividends compared to equity REITs which is taken into account with their relatively higher total returns. Please see " Positioning Your Portfolio For Higher Interest Rates " which predicted improved net interest margins driving 90% of BDCs to increase their dividends over the last two years. Most BDCs continue to position their portfolios away from cyclical sectors and into growth, technology, and defensive sectors that will continue to do well over the coming quarters. Also, almost every BDC used the pandemic to strengthen their balance sheets with longer-term unsecured borrowings at extremely low fixed rates many of which have recently increased their dividends. These changes have resulted in much stronger balance sheets ready for anything from an economic recession to an overheated economy driving inflation and higher interest rates.

The average dividend coverage was 131% for Q2 2023 compared to 124% for Q1 2023 largely due to continued increases in portfolio yield with many BDCs easily beating their best-case projections driving another round of dividend increases (regular and/or supplemental). Even if the underlying rates eventually go lower, there's a good chance that most BDCs will continue to over-earn their regular dividends. The following chart shows the average dividend coverage over the last 10 years with the last four quarters averaging over 120% even after taking into account the recent and previous dividend increases. Many BDCs have opted to take a conservative approach when setting their regular dividends (just in case rates head lower) and using supplemental/special dividends to pay out excess earnings. This means that if portfolio yields decline, we will see lower amounts of supplemental/special dividends but the regular dividends will be maintained especially "Level 1" dividend coverage BDCs which are the ones that can cover their regular dividends by at least 90% using the lower-yield Leverage Analysis with a debt-to-equity ratio of 0.80.

Summary and Takeaways

The only time I use tables with calendar measurements of total returns is to compare with other investments over the same period. However, nobody buys a stock at the end of the trading day on Dec. 31 and simply holds without buying more on the dips. At least not my savvy subscribers, as discussed in " Build Your 10% Dividend Yield Portfolio ," using volatility to increase returns easily beating the S&P 500.

Upcoming articles will discuss portfolio allocations for BDCs and REITs, total return comparisons for longer periods , and other considerations including risk and pricing volatility. Also, investors can easily make higher returns by taking advantage of pricing volatility and I will provide examples of my recent purchases. The following table includes the return comparisons from the previous tables with some quick takeaways below.

What's the best way for yield-oriented investors to maximize their returns over the long term while earning solid dividends?

• Adjust portfolio allocations including higher amounts of BDCs compared to REITs as they have been outperforming over the long and short term. Again, I will provide return comparisons for long periods in upcoming articles.
• For the same amount of income with less risk, it's better to invest 50% less capital in BDCs at 11.5% compared to equity REITs at 5.0% to 5.3%.
• If you're investing mostly for higher yield it's better to use a typical/average BDC vs. mREITs.
• Do not use ETFs (such as BDCZ/ BIZD ) to invest in the BDC sector as they have historically reduced the distributions paid (even when many BDCs are increasing), with higher price volatility during downturns, and continually underperform due to poor allocations and fund fees as discussed in " ETFs Are The Worst Way To Invest In The BDCs ."
• For your REIT allocation, you can use VNQ which outperforms the average but with a lower yield. Also, VNQ has much better diversification than BIZD/BDCZ simply due to the size of the sector.
• Mortgage REITs are terrible long-term holdings but can provide higher yields and returns if traded correctly. REM has a lower yield but also could reduce the risk for that portion of the sector.

Please do your due diligence and set appropriate target prices. There are very specific reasons for the prices that BDCs trade driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage).

• BDCs with higher-quality credit platforms and management typically have higher-quality portfolios and investors pay higher prices. This drives higher multiples to NAV and lower yields.
• BDCs with lower expenses and higher potential dividend coverage typically have stable to growing dividends and investors pay higher prices. This drives higher multiples to NAV and lower yields.

For further details see: