New Subsection, New Question

[Dividend Watcher]

I see passing references to the high yield, low growth segment of the market yet have never really looked into it very far. My first gut reaction (and second and third), is that moving that far into the yield curve when so many "mainstream" stocks are only yielding 1-4% is a risky proposition. Yet some of you seem to handle it well.

So, let's start with a BDC. Tell me about one and how you've managed the ups and downs in both share price and dividend. How much and what do you monitor? What do you look for to enter a position and when do you think about selling -- or do you sell?

[Robandcindy2]

I start with a guy on SA, BDC Buzz and follow his "Low Risk-Total Return" portfolio:

http://seekingalpha.com/article/2301385-...t-36628125

You can get an email alert for free or subscribe. As with Brad Thomas of iReit Investor, they seem to track these niches closely.

I have all six of the Total Return BDC's. Total BDC sector is 2% of our portfolio ... Now....

[Be Here Now]

I currently own 5 BDCs and one BDC related ETN. My positions are ARCC, BDCL (the ETN), GBDC, HTGC, NMFC, and TCPC.

I have 2 sources of information. One is BDC Buzz on SA, mentioned above. The other is research produced by Wells Fargo, my broker.

The Wells Fargo research team has much more resource to spend on analyzing BDCs than BDC Buzz - more manpower, more time, more money. Their research is the best I have seen for both depth and breadth. They divide their research universe into 4 tiers, and they use many criteria to grade BDCs. I want my BDC dividends to be as secure as they can be, and the top tier are their best picks for both dividend security and NAV growth. I invest exclusively in their top tier; the only BDC I own that is not in their top tier (NMFC) was there at one time, and I haven't seen a good reason to drop it.

BDC Buzz cannot hope to match a highly paid research team, but his analyses are excellent and he arrives at conclusions that match closely those of Wells Fargo. He places heavy emphasis on the alignment of management interests with owner interests. I want my companies to be managed by those who demonstrate a clear commitment to my financial well being, and BDC Buzz does an excellent job of revealing the spectrum of management attitudes. What he cannot do is in depth analysis of the various BDCs' portfolios. For that I look to Wells Fargo.

Both WF and BDC Buzz provide the other data point that I am very interested in, namely the effect that rising rates might have on net investment income (NII). There is a spectrum of borrowing strategies used by BDCs. Some borrow at fixed rates, some borrow at variable rates, some use a combination. Part of the income protection I want is to have a good idea what will happen to the dividend if borrowing rates increase. You can get this information from 10-K and 10-Q filings for some BDCs but not all. I learned how to find this information from BDC Buzz. For those BDCs that do not provide this information directly, I rely on both WF and BDC Buzz to run the financials for me. I want to own only those BDCs whose NII will not be negatively impacted by rising rates insofar as the BDCs balance sheets are concerned. Whether or not the companies they lend to will be able to pay increased interest on their variable rate borrowing is another matter that neither WF nor BDC Buzz can be expected to predict with as much accuracy.

The BDC universe was recently roiled by the decision by S and P and Russell to remove BDCs from their index funds. There was a panic selloff, and like most such, it provided some wonderful buying opportunities. One of my favorite BDCs, HTGC, was a case in point, and I owned it at the time this happened. On April 1, HTGC traded in the range of 12.95-14.36, and closed at 13.81, down 0.26 or -3.85%. There were two items of note: 1) volume was much higher than normal, and 2) the close was much higher than the daily low. This told me two things: 1) the selling was done by institutions (i.e. SnP and Russell funds) that were forced to remove HTGC from their books, and 2) there was buying strength into the close. Given the volume, the buyers had to be predominantly institutions, and they were not the funds and ETFs that were forced to sell HTGC. In other words, smart money.

I was not following HTGC on that day, or I would have placed a buy order to increase my position. Since I missed it, I decided to wait for any subsequent forced selling that might occur before June 26 (the last day for the Russell funds to rebalance). I saw an opportunity on May 15 and 16, when HTGC was trading under $14 and appeared to be in the final phase of building a base, and the yield was close to 9%, so instead of being greedy and waiting for exactly 9% I bought on both days. HTGC subsequently ran up as high as $16.50 and is very close to that now.

I have sold several BDCs, and the one sale that might interest most people was PSEC. I owned it for the high dividend, even though WF rated it in tier 4 - a violation of my own rule! Wells Fargo produced a detailed report that showed how their high cost of new capital, compared to the tier 1 BDCs, was forcing PSEC to make risky investments. BDC Buzz emphasized how high their fees are compared to the best BDCs. I finally decided to follow my own rules and sell all of PSEC, which I did on April 8. This was just plain lucky because the announcement about dropping the BDCs from SnP and Russell was made several days later. I missed all the subsequent downside in PSEC.

BDCs now constitute 11.5% of my portfolio. My target is 14%. I want to start a position in MAIN, and I want to increase positions in GBDC and TCPC.

[Ok Red]

Excellent post, BHN!

One thing that has not yet been discussed is Yield on Cost, which is my real interest in HYLG.

I'll use MAIN for an example. I plugged in the following variables into FAST graphs - $10,000 invested over a 6 year time period with dividend reinvested. Average DGR over that time period is only 5.8%. But... YOC at the end of year one was 9.9%, year two was 11.2%, year three was 13.1% and year four was 15.2%. Yes, it's historical data, but is still very illuminating.

Now, one of my favorite LYHG stocks over that same time period - UNP - gives the following results with the same variable. Average DGR over that time period is a stunning 29%. YOC at the end of year one was 2.1%, year two was 3.1%, year three was 4.1% and year four was 5.0%.

Wow. Considering that I want to have the option to retire in about 6 years, MAIN (or similar HYLG equities) give me a huge advantage over that time period.

It's also clear that eventually the LYHG will catch up and overpass the HYLG equity. When that occurs is the pertinent question. For those of us with short time frames to retirement, that is the key.

Interesting stuff....

[Be Here Now]

(07-08-2014, 11:27 PM)Ok Red Wrote: It's also clear that eventually the LYHG will catch up and overpass the HYLG equity. When that occurs is the pertinent question. For those of us with short time frames to retirement, that is the key.

Let's analyze the same two companies using dividend data from longrundata and the CCC list.

The 1 year DGR for UNP is 18.9%, so you can see the rate of increase is slowing. According to Robert Allan Schwartz' database, a dividend growth rate of 20% has been maintained by only one company for at most 9 years, so we can expect 18.9% to be the maximum DGR going forward. Its current yield is 1.70%.

The 1 year DGR for MAIN is 55%. That is clearly not maintainable for even one year, so lets call it 8% going forward. Its current yield is 6.10%.

If you were to make 2 investments like these two, today, and were interested only in the dividend dollars received (retired and spending the income), then the cumulative income received from MAIN would exceed the cumulative income received from UNP for 20 years (taxes ignored). We know that UNP will not maintain 18.9% growth for 20 years, and realistically not for 10. If we assume 15% instead of 18.9%, then it takes 28 years for UNP to match MAIN. If we assume 10% instead of 15% then UNP never catches MAIN.

This analysis really has nothing to do with how you invest before retirement. Until you retire, you do not necessarily need to invest in MAIN in preference to UNP. If I were in this position, I would want to maximize my portfolio value at my retirement date, and then convert to HY stocks if I did not already own them. In other words, deciding you want to own HY stocks during retirement does not necessarily mean you need to own them before retirement. My guess is 'not' because you can pretty easily prove to yourself that HY is not high total return. Stocks that yield 3-4% are in the sweet spot for dividend total return.

I have developed a spreadsheet that compares the total income received from two different investments, each with its own starting yield and dividend growth rate, no reinvestment. If you are interested, PM your email address to me at Seeking Alpha.

[EricL]

(07-09-2014, 01:49 AM)Be Here Now Wrote:

(07-08-2014, 11:27 PM)Ok Red Wrote: It's also clear that eventually the LYHG will catch up and overpass the HYLG equity. When that occurs is the pertinent question. For those of us with short time frames to retirement, that is the key.

Let's analyze the same two companies using dividend data from longrundata and the CCC list.

The 1 year DGR for UNP is 18.9%, so you can see the rate of increase is slowing. According to Robert Allan Schwartz' database, a dividend growth rate of 20% has been maintained by only one company for at most 9 years, so we can expect 18.9% to be the maximum DGR going forward. Its current yield is 1.70%.

The 1 year DGR for MAIN is 55%. That is clearly not maintainable for even one year, so lets call it 8% going forward. Its current yield is 6.10%.

If you were to make 2 investments like these two, today, and were interested only in the dividend dollars received (retired and spending the income), then the cumulative income received from MAIN would exceed the cumulative income received from UNP for 20 years (taxes ignored). We know that UNP will not maintain 18.9% growth for 20 years, and realistically not for 10. If we assume 15% instead of 18.9%, then it takes 28 years for UNP to match MAIN. If we assume 10% instead of 15% then UNP never catches MAIN.

This analysis really has nothing to do with how you invest before retirement. Until you retire, you do not necessarily need to invest in MAIN in preference to UNP. If I were in this position, I would want to maximize my portfolio value at my retirement date, and then convert to HY stocks if I did not already own them. In other words, deciding you want to own HY stocks during retirement does not necessarily mean you need to own them before retirement. My guess is 'not' because you can pretty easily prove to yourself that HY is not high total return. Stocks that yield 3-4% are in the sweet spot for dividend total return.

I have developed a spreadsheet that compares the total income received from two different investments, each with its own starting yield and dividend growth rate, no reinvestment. If you are interested, PM your email address to me at Seeking Alpha.

This is especially true when investing in a tax sheltered account, where the only costs of switching from UNP to MAIN at retirement are the $20 or so in broker costs you'll be charged for selling one and buying the other.

It becomes a bit more complicated in a cash account however, where you will need to weigh the effect of taxes on capital gains.

[Be Here Now]

There is another data point that I use when evaluating BDCs. Since BDCs must distribute 90% of their income to maintain their tax status, they cannot use retained earnings to finance most of their investments. They must periodically go to the capital markets for additional investment capital, either new shares or new debt.

If a BDC issues new shares at a price below net asset value, this is expensive capital. If a BDC must pay comparatively high interest for its new debt, this is expensive capital.

The technical term for the total cost of a company's capital is weighted average cost of capital or WACC.

Obviously, you want your BDC to have a low WACC. Low WACC lets it invest in less risky loans, typically senior debt, the debt at the top of the capital structure. This debt pays less interest than subordinate debt because it has the least default risk. This creates a virtuous circle. Low WACC lets you invest in low risk debt and still maintain a profitable spread between your cost of capital and your investment income. If your WACC is high then you must invest in riskier debt to maintain a similar spread, and it is more difficult to cover your dividend with investment income because you are more likely to make investments that go bad and must be written off.

PSEC is a good example of a BDC with comparatively high WACC, and HTGC the opposite. As long as economic conditions are favorable, PSEC should be able to maintain its dividend. However, the next recession could put a lot of strain on PSEC.

Take a look at the price-to-NAV ratio of PSEC and compare to HTGC or MAIN. As of this writing, P/NAV for PSEC is 1.02:1, HTGC is 1.57:1, MAIN is 1.78:1. The markets are valuing HTGC and MAIN much higher than PSEC, and I think with good reason.

I am willing to accept the lower yield of HTGC in preference to PSEC just so I can SWAN. If I want to increase my portfolio yield from BDCs I can allocate a small percentage of my BDC positions to BDCL. I think a lot of HTGC and a small amount of BDCL is less risky than all PSEC and can generate equivalent income to PSEC. This is what I have done.

[Dividend Watcher]

(07-08-2014, 11:27 PM)Ok Red Wrote: It's also clear that eventually the LYHG will catch up and overpass the HYLG equity. When that occurs is the pertinent question. For those of us with short time frames to retirement, that is the key.

This struck me as an important factor in the mindset needed to approach these stocks.

If I was 30yo, would I necessarily need the HYLG stocks in my portfolio? From my vantage point, probably not. I don't think it would meet the SWAN principle for me and I probably wouldn't have enough experience or patience to withstand the volatility in price and dividend. As each year ticks off the calendar though, I'm beginning to take more of an interest -- if anything to build up cash in the "Immediate Needs" bucket.

I haven't had time to read any of BDC Buzz's articles yet and don't have access to Wells Fargo research so don't have the nitty gritty details of what I should look for when buying or selling. The concept of how they do business is simple in the abstract but the devil is in the details.

What pertinent statistics do you look at either for the buy or sell side? I guess I haven't fleshed that out yet.

Thanks BHN for the information so far. This section of the market has always struck me as too risky so I've never delved very far into them.

[Kerim]

Interesting discussion. When I think of HYLG, it is stocks like T that jump to mind, not risky esoteric high-yielding stuff.

T is boring but reliable, but it will be many years before a LYHG stock will overtake it. So again, your time horizon matters. And of course, your faith that the HG stock can and will continue its dividend growth pace for all of that time.

[Be Here Now]

(08-10-2014, 07:59 AM)Kerim Wrote: And of course, your faith that the HG stock can and will continue its dividend growth pace for all of that time.

Robert Allan Schwartz' web site has very interesting statistics on how long any particular CCC company has maintained a high growth rate: http://www.tessellation.com/dividends/streaks.html

Robert also recently published an article on Seeking Alpha on the same topic: http://seekingalpha.com/article/2344395-...rowth-last

[hendi_alex]

I'm glad to see this kind of discussion as IMO there is room for HYLG stocks in most income investor's portfolios. However, I am bothered when I see BDCs and MREITs being discussed as if they represent reasonable risk adjusted investments comparable to other investments. These classes of investments are mostly spread plays that work only so long as the interest rate climate is favorable. When rates and spreads turn in the wrong direction dividends are cut, very often loan covenants are breached, and the number of failed companies among these lenders explodes. A huge number of big names from the previous cycle no longer exist or are tiny shells of their former businesses. The sector is sometimes worthy of investment, but only during the favorable part of the cycle. I currently hold no BCDs or MREITs but will accumulate up to 20% weighting on the other side of the cycle. These are pure timing plays, are generally not suitable for the buy and hold or risk averse investor, and most current investors will get taken to the cleaners when the eventual stampede begins. The average investor should look elsewhere for HYLG candidates.

[Be Here Now]

I am in the midst of taking a sizable rollover into a new traditional IRA. As a retiree who depends on investment income for a significant part of my spending needs, and as the instigator of the HYLG discussion, I have been working on an appropriate allocation for my cash. I am writing about it here so that the younger investors who post here, who appear to be in the great majority, can have some insight into what life might bring your way in the future. And who knows, the older folks might get something out of this too; I have had inquiries on SA from retirees on this very subject. So here goes.

To elaborate, I need high income now rather than later; I do not value LYHG nearly as much as HYLG because I need the 'Y' now. At the same time, I do not want to take an unreasonable amount of risk, as I define risk, which for me is a significant loss of current income.

I developed a list of stocks with a range of medium to high incomes that I think could meet my needs for both current income and risk minimization if I own them in the right proportions. The method I chose was to own them in quantities such that each position generates the same amount of income. If, for instance, I own 15 different stocks, then if any one stock stops paying a dividend I will lose at most 1/15th of my income.

This is the portfolio I expect to own. Sorted on symbol.

   

Two of these are leveraged ETNs: HDLV and MLPL.

HDLV is linked to an index that is heavy on telcos and utilities. MLPL is linked to the Alerian MLP Infrastructure Index, i.e. midstream MLPs. The risks attached to these are (among others) 1) they are ETNs so there is counterparty risk, and 2) they are 2x leveraged. Balancing these risks are the businesses that make up the linked indexes. These businesses are stable, and the midstream MLPs are growing. My portfolio risk is further mitigated by my allocation strategy; they are the two smallest holdings by market value.