Forget High Yield Bonds And Preferreds: Buy This Instead

It is no secret that interest rates have risen sharply over the past year due to the Federal Reserve’s aggressive efforts to crush inflation:

As a result, interest sensitive fixed income investments like bonds (BND) and preferred equities (PFF) took a beating in 2022:

As a result, yields for both rose accordingly:

With this opportunistic increase in yields on fixed income, some investors decided to shift away from their overweight allocations to equity index funds like SPY, QQQ, and DIA, and instead increase their allocations to fixed income in order to capitalize on these higher yields and more defensive investments ahead of an increasingly likely recession.

While we can see the appeal of these investments – and have in fact recently increased our allocation to investment grade fixed income securities where the yields are in the high single digits while the risks are low in accordance with the investment grade ratings applied to these securities – we do not see the point of investing in junk-rated preferreds and bonds.

The reason? We are investing aggressively in Business Development Companies (i.e., BDCs) (BIZD). While BDCs are generally more volatile than junk rated bonds and some junk rated preferreds, we believe that they continue to offer among the most attractive risk-adjusted returns in the debt/preferred equity space for the following reasons:

#1 – Superior Underwriting Performance

While investing in individual bonds and preferred equities can be fun, it is also a lot of work. These securities do not have nearly the research coverage that common equities do and the vast majority of analyst questions and even management investor presentations highlight the equity over the preferreds and bonds. As a result, doing thorough due diligence can often be very time consuming. While this is not necessarily a problem, if you can hire a large, talented, and experienced team to do this research for you, why not?

In the BDC space, there are major powerhouse global alternative asset managers like Brookfield (BN)(BAM) and Oaktree (OAK)(OCSL), Blue Owl (OWL)(ORCC), Blackstone (BX)(BXSL), Ares Management (ARES)(ARCC), and KKR (KKR)(FSK) that have hundreds of billions of dollars in assets under management, have immense amounts of proprietary insights and data points, enormous business networks, and employ large teams of highly skilled and experienced professionals to build and manage the investment portfolios at their respective BDCs. These teams often generate tremendous results, with several of these aforementioned BDCs currently have zero investments on non-accrual despite investing in debt and preferred equity at high single-digit yields.

Several of these businesses have also proven to weather challenging macroeconomic circumstances such as the COVID-19 lockdowns and the Great Financial Crisis with flying colors. In fact, in the debt and preferred equity investing space, investing alongside large asset managers like these is especially valuable because they generally take a more active role in their portfolio companies than typically takes place with investors in corporate debt and preferred equity. For example, if one of the companies that BX or ARES lends to runs into financial difficulty, they can and often do leverage their large investment teams and considerable market knowledge and resources to get involved and help the company survive or at the very least minimize the loss of their capital.

In contrast, if a company whose preferred equity or debt you are invested in through the public markets runs into distress, it is not uncommon for the average retail investor to get taken advantage of and to end up holding the bag. This is especially common in the case of preferred equity, but has also been known to happen in some cases with bonds.

#2 – Greater Liquidity

Publicly traded BDCs generally have tremendous liquidity with very narrow bid-ask spreads. In contrast, most corporate bonds and many preferred equities have wide bid-ask spreads with much less liquidity in the public markets. Furthermore, some brokers still charge commissions for fixed income trading whereas virtually none of them charge commissions to trade BDCs. This makes trading BDCs much easier and more efficient than investing in bonds and preferred equities.

#3 – Easy Diversification

BDCs also generally hold broadly diversified portfolios of debt and preferred equity across many industries, giving investors diversification that is akin to what is enjoyed in many mutual funds and ETFs. In effect, BDCs are very actively managed debt and preferred equity mutual funds that hold proprietary sourced and managed investments.

With the click of a mouse, investors can access an expertly underwritten, managed, and diversified portfolio of debt and preferred equity instead of having to spend countless hours to build a similarly diversified portfolio of hand-picked preferred equity and debt investments through the public markets.

#4 – Attractive Cost of Capital

Another big advantage that investing in BDCs enjoys over investing in bonds and preferred equity is that the investor gets access to a much cheaper cost of capital. In order to enhance returns on bonds and preferred equity, investors can either take out a loan that comes with personal liability and often a high interest rate along with other fees or use margin (which is effectively playing Russian Roulette with your portfolio). Additionally, to grow the equity component of your investment, you must deposit more of your own money.

In contrast, BDCs – especially investment grade ones – have the ability to issue their own debt at very attractive rates and on attractive terms. As a result, your investment can enjoy leveraged returns without the risks involved with margin nor the costs, hassle, and personal liability that come with taking out a loan yourself. Furthermore, BDCs often trade at a premium to their net asset value and then will take advantage of it to issue new equity at those prices. They can then combine this with their attractively sourced debt to invest in new loans and preferred equity. In so doing, they increase their net asset value and earnings per share, thereby growing investor’s wealth over time.

#5 – Floating Interest Rates

A final reason why we have generally favored investing in BDCs over most bonds and preferred equity is because they often have significant exposure to floating interest rates. Given that interest rates had been stuck near historical lows for over a decade until 2022 and that equities and most bonds and preferred equities get hit hard by rapid increases in interest rates, allocating a portion of our portfolio to floating interest rate investments such as what BDCs do helped to improve our overall portfolio diversification and risk-reward profile.

As a result, it should not surprising to see that BDCs significantly outperformed the broader stock market in 2022 given rapidly rising interest rates and fairly stable economic fundamentals resulting in record profits for many BDCs. This in turn led to some very impressive dividend growth across the sector.

A clear example of this is seen in one of the very largest and most popular BDCs: Ares Capital Corp. (ARCC). On their latest earnings call, ARCC’s management said:

We elected to raise the regular quarterly dividend from $0.43 to $0.48 per share because the company is now experiencing a higher level of core earnings, primarily due to the substantial increase in base rates. This increase, the largest quarterly increase in our company’s history, is our third increase this year and results in a regular dividend that is 17% higher than our regular quarterly dividend level at the end of 2021.

The higher base dividend that we are paying also reflects our positive outlook on our ability to generate this level of core earnings under a variety of interest rate and economic scenarios for the foreseeable future.

Investor Takeaway

While BDCs are far from risk-free investments, for the reasons mentioned in this article we believe that they provide superior risk-reward over junk-rated bonds and preferred equities. This is especially true in the current rising interest rate environment as they help to balance out some of our investments in sectors like utilities (XLU) and REITs (VNQ) which tend to suffer from rising interest rates.

Thus far, we have been richly rewarded for our investment into our top picks in the sector and plan to maintain substantial exposure as our top debt investment in 2023 and quite possibly beyond.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.