CGBD - Ride Out The High Yield Carnage With Carlyle Secured Lending's 11% Yield

2023-03-15 06:23:53 ET

Summary

• Carlyle Secured Lending has high credit quality and a safety-first investment approach.
• The portfolio is well-diversified and well-performing.
• Investors can presently buy up CGBD at a 19% discount to net asset value.

The failure of Silicon Valley Bank (SIVB) last week shocked the high yield market, causing the valuations of business development companies to plummet.

Passive income investors that are worried about the carnage in the high yield market, however, have now the opportunity to buy, or double down on, high quality business development companies that are well-managed and have strong, defensively positioned investment portfolios that can sustain the volatility.

Carlyle Secured Lending ( CGBD ) , a BDC that I believe is worthwhile purchasing at this point, provides passive income investors with a robust 11% yield, good dividend coverage, and a productive credit portfolio.

Portfolio Composition, Safety and Growth

The BDC arm of the prominent alternative asset manager Carlyle Group is called Carlyle Secured Lending. The company originates loans to middle market businesses, the majority of which are First Liens, just like the majority of other business development companies do.

68.6% of Carlyle Secured Lending's investment assets were placed in highly rated first liens at the end of 2022, followed by 13.3% in second liens, 4.8% in equity, and 13.3% in investment funds. For some time, the company's portfolio was defensively positioned, and going forward, it should be expected that the BDC will continue to prioritize safety and First Liens.

Looking at the loan origination activity for Carlyle Secured Lending in the fourth quarter, we can see that the vast majority of loans (98%) were originated in the First Lien category. Having said that, the number of new originations has significantly decreased over the past 12 months.

The aggressive rate-hiking cycle of the central bank is to blame for the 46% YoY decline in new investment fundings at the BDC.

As of December 31, 2022, the investment portfolio of Carlyle Secured Lending was valued at $1.98 billion and primarily comprised floating-rate senior secured loans. The portfolio continued to be well-diversified along industry groups and included 134 portfolio companies. Carlyle Secured Lending is overweight sectors like healthcare (11%), business services (8%) and software (8%), which have steady cash flows and are less susceptible to economic downturns.

The portfolio of Carlyle Secured Lending generates a very respectable 10.7% yield based on a $0.37 per share regular payout per quarter. The base dividend is increasing, though, and the BDC increased its payout three times in 2022 and once in 2023. In order to distribute excess income, Carlyle Secured Lending also pays special dividends.

The BDC reported a pay-out ratio of 69% in 2022, which was sufficient to pay a respectable amount of supplemental dividends on top of the regular dividend because net investment income had adequately covered it.

The BDC fully covered the supplemental dividends, which totaled $0.30 per share in 2022, with NII as well. Carlyle Secured Lending distributed 85% of its net investment income, including all special dividends.

19% Discount To Net Asset Value

Due to the Silicon Valley Bank fiasco, investors fled the market last week out of concern for contagion, which increased the discount to net asset value. In the case of Carlyle Secured Lending, the discount to NAV increased from 0.90x to 0.81x last week.

Given the BDC's strong performance and high-quality portfolio, I believe the discount is excessive. In the long run, I believe the stock may even trade at or near book value (provided that credit quality doesn't decline).

Risks with Carlyle Secured Lending

The dangers faced by Carlyle Secured Lending are the same as those faced by other business development organizations that originate loans.

For Carlyle Secured Lending, rising interest rates and inflation present both a risk and an opportunity. Due to the BDC's positioning in the floating rate portfolio, they indirectly translate into higher portfolio income.

On the other hand, lower borrowing and lending activity as a result of higher interest rate costs could eventually lead to a slower rate of asset growth.

My Conclusion

A well-run business development company, Carlyle Secured Lending offers a defensively positioned credit portfolio with a strong focus on safety and upside potential from floating rates.

Although I haven't previously discussed Carlyle Secured Lending, I believe that the BDC is very well-positioned to capitalize on the extremely large discount to net asset value. Net investment income covers the 10.7% dividend yield.

I believe that Carlyle Secured Lending is on a solid trajectory and that the stock has the potential to close the gap between its market price and net asset value, even though originations decreased in 4Q-22 compared to last year as a result of higher interest costs for borrowers.

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