2023-06-29 10:05:00 ET
Summary
- Capital Southwest's floating-rate portfolio benefits from rising interest rates, which have led to an increase in its interest income and a strong dividend yield of 11%.
- While there are risks associated with a potential recession and an increase in credit defaults, Capital Southwest's portfolio currently shows low credit risks.
- Capital Southwest's dividend yield is attractive, and its valuation is not high for the current interest rate environment.
Article Thesis
Capital Southwest ( CSWC ) is a major business development company, or BDC, that offers a strong dividend yield of 11%. Rising interest rates are positive for most BDCs, and while a potential recession poses some risk for CSWC, the company nevertheless looks like a good investment.
Rising Interest Rates As A Tailwind For BDCs
Interest rates have exploded upwards in 2022 and continued to climb in 2023, as we can easily see in the following chart:
The Federal Funds rate had been almost zero for years during the cheap money days of the pandemic, but high inflation rates forced the Fed and other central banks to tighten monetary policy.
Higher interest rates generally are bad for consumers, as financing a new vehicle, new furniture, and so on becomes more expensive, while credit card debt becomes costlier as well. Of course, purchasing a home becomes more expensive as well for those that use leverage. On the other hand, lenders can generate higher returns on their loans. This is why banks oftentimes see their net interest income climb during times of rising interest rates, as the rate they lend money at rises faster than the rate they pay on deposits.
A similar trend is visible when we look at BDCs, which are lenders as well -- like banks, many of them benefit from higher interest rates. This either happens when the loans they have made are floating -- in this case, there is an immediate impact -- or it happens when BDCs can make new loans at higher rates once old loans mature and are paid back.
We see this positive macro trend impacting Capital Southwest's results in the recent past, including during the most recent quarter. In its fiscal fourth quarter , which was reported around a month ago, Capital Southwest was able to generate interest income of $32 million, which was up by double-digits and which was almost twice as high as the interest income that CSWC generated during the previous year's period. Other revenue sources did not grow as much, such as dividend income and fee-based income, which were essentially flat -- dividend income and fee-based income do not benefit from higher interest rates, after all. Higher interest rates were not the sole driver of higher net interest income, however, as Capital Southwest also became larger over the last year.
Not surprisingly, the company thus had to pay out more to its employees, and CSWC also saw its interest expenses climb compared to one year earlier. Still, the overall effect was clearly positive, as pre-tax net investment income jumped from $13 million to $23 million, for a nice 77% increase in a single year.
Capital Southwest does, like many other BDCs, issue shares from time to time in order to generate additional capital that can be used to make new loans and to grow the company. On a per-share basis, CSWC's growth has thus been less pronounced compared to a company-wide basis. Still, even on a per-share basis, Capital Southwest has generated highly appealing growth over the last year, as pre-tax net investment income per share rose by 30%, hitting a record level of $0.65 during the most recent quarter. Sequential growth continued, as it had for a couple of quarters in a row -- which aligns very well with the fact that rising interest rates are positive for profits. Since interest rates have risen for several quarters in a row, profits have done so as well, climbing by 8%, 11%, and 8%, respectively, over the last three quarters (on a sequential basis, the respective year-over-year growth rate was better).
Looking at how Capital Southwest is financed, we see the following:
The company has a significant amount of debt that was locked in at relatively low interest rates for a prolonged period of time. In the current rising rates environment, that's a great asset: The cash that CSWC borrowed for as low as 4.5% can be deployed at much higher yields, making for a very attractive spread. This is part of the explanation for Capital Southwest's attractive net investment income growth rate in recent quarters.
98% of Capital Southwest's credit portfolio is floating-rate, giving the company immediate exposure to further interest rate hikes -- which, according to statements of Fed members, are likely in the coming months.
The company details what the impact of interest rate movements would look like going forward:
We see that another 50 base point hike would add around $4 million per year to Capital Southwest's net investment income, or around $1 million per quarter. The earnings per share impact would be $0.12 in this scenario. The same principle holds true when interest rates move in the opposite direction -- in that case, CSWC will experience an earnings decline. If one expects that interest rates will head down lower in the near term, CSWC does not seem like an attractive pick. However, I do believe that this is rather unlikely, as inflation has remained well above the target range of 2%, which means that the Fed will likely remain hawkish for the foreseeable future. At least according to Fed members, further interest rate increases are more likely than interest rate reductions in the near term.
Risks: Not Negligible, But Not Very High, Either
Not too long ago, markets were worried about the risks for business development companies. And there are, indeed, some risks to consider. Rising interest rates have made a recession more likely, all else equal, and recessions generally cause an increase in credit defaults.
It is not guaranteed that we will experience a recession in the second half of the current year or in 2024, but many analysts and investors do see this risk on the horizon. If we get into a recession, some of Capital Southwest's portfolio companies could run into trouble, and it is possible that CSWC will experience some losses in its credit portfolio -- the same holds true for other BDCs.
Luckily, the portfolio looks pretty strong when it comes to credit risks right now. The portion of Capital Southwest's loans that are on a non-accrual basis is just 0.3%, which is low in absolute terms, and which is also low compared to where that ratio stood in the past -- one year ago, the ratio stood at 1.6%. Over the last year, Capital Southwest's portfolio companies have thus become a lot stronger, or, in other words, credit risks have declined meaningfully.
A High And Safe Dividend Yield
Business development companies are income investments primarily, and that also holds true for Capital Southwest. The company currently trades with a dividend yield of 11.0%, based on a share price of $19.70 and an annual dividend payout of $2.16.
Capital Southwest's dividend is paid out in quarterly installments of $0.54 following a 2% dividend increase earlier this year. The company is forecasted to earn $2.59 this year, which makes for a payout ratio of 83% -- that would be quite elevated for a "normal" company, but is pretty normal for a BDC, as those operate, like REITs, MLPs, and so on, with elevated payout ratios.
Capital Southwest makes supplemental dividend payments regularly, but those are not always equally large. From time to time, CSWC also makes special dividend payments, the last one of which was paid out in the summer of 2022 ($0.15 per share). CSWC's regular dividend payments have been climbing relatively reliably for the last couple of years, and unless interest rates head drastically lower, I would not be surprised to see this dividend growth track record remain in place.
Final Thoughts
Capital Southwest is a high-quality BDC that benefits a lot from the current interest rate environment. The dividend yield is attractive, the valuation is far from high -- the earnings multiple is just 7.5 -- and credit risks exist, but aren't especially large. Overall, I like Capital Southwest stock right here, although it's a less exciting buy compared to a couple of months ago when the valuation was even lower and the dividend yield even higher -- we last covered CSWC in early January, and the stock has delivered more than 20% since then.
For further details see:
Capital Southwest: This 11% Yield Is Great