Dependable High-Yield Income Found in 2 Best-of-Breed BDCs

Call it guilt by association. Business development companies (BDCs) have sold off with junk bonds over the past week.
The association is understandable: Junk bonds are loans to lower-quality credits. BDCs issue loans to lower-quality credits. Junk bonds have been issued by many middle-market companies – shale producers, software developers, clothing manufacturers. BDCs have lent to similar companies.
The guilt is equally understandable. Many junk-bond funds loaded up on low-quality debt issued in the energy sector. Recently defunct Third Avenue Focused Credit Fund (TFCVX) was particularly hot on energy, and even hotter on yield. Many of the bonds it bought were issued by debt-laden small-time U.S. shale producers. Many BDCs have aggressively lent to similar precarious energy producers.
When a sector is found guilty, selling is frequently wholesale and encompassing. This is what we’ve seen with BDCs. But rarely should selling be wholesale and encompassing. There are always a few babies floating in the out-flowing bathwater.
Golub Capital BDC (NASDAQ: GBDC) is one of the babies. Its shares sold off last week, and the sell-off has driven the yield up to 7.6%. This is despite the fact that the dividend has never been reduced and has paid $1.28 per share annually for the past couple years.
Golub is a quality BDC that investors should consider reeling back in. Golub runs an investment loan portfolio of 164 investments. These investments are spread across a wide swath of industries: health care, diversified services, retail stores, electronics, and food and beverage round out the top five. Of the industries listed by Golub, energy is nowhere to be found.
More important, Golub’s portfolio is fundamentally sound. Credit quality remains strong, with non-accrual investments as a percentage of total investments at fair value increasing slightly to just 0.4% in the latest quarter. Over 90% of Golub’s portfolio have an internal performance rating of 4 or higher. This means the borrower is performing as expected and the risk factors are neutral to favorable.
Performance is reflected in income yield. On that front, the weighted average income yield on Golub’s portfolio was 8.8% in the latest quarter. A year ago, the yield was 8.3%.
When investing, the future is always center stage. Therefore, it’s worth noting that 99.7% of Golub’s loans are floating rate. This means that with interest rates on the rise, the income derived from Golub’s investment portfolio will rise as well.
Ares Capital Corp. (NASDAQ: ARCC) is the other baby worth keeping. Ares is one of the largest BDCs. It also happens to be one of the highest-yielding BDCs, with a 10.7% yield.
Ares’ $8.7 billion investment portfolio is composed of 200 investment companies that, like Golub’s, cover a wide range of industries: health care, consumer products, manufacturing, retail, container packaging and financial services. Yes, oil and gas lending is part of the mix, but it accounts for only 3% of the portfolio.
Also like Golub, Ares’ portfolio continues to perform. In the third quarter, Ares reported net investment income of $130.5 million, or $0.42 per share. In the year-ago quarter, Ares reported $105.3 million, or $0.34 per share. Ares continues to safely cover its $0.38 per share quarterly dividend.
The potential for even more dividend coverage is also there. Of Ares’ investments, 91% are secured loans and debt. Of the loans, 81% are floating rate. The weighted average yield on the entire investment portfolio is 9.4%. On the other side of the ledger, Ares has $3.7 billion in debt financing. Over 95% is fixed rate, with an average interest rate of 5.2%. Floating rates rise, fixed rates remain the same, and margins expand.
Ares’ potential for more income has yet to resonate with investors. At the end of the third quarter, its net asset value per share was $16.79, a $0.08 increase compared to NAV a year ago. This time last year, Ares shares were trading at a 2% discount to NAV. Today, they trade at a 13% discount. Over the past decade, Ares shares have typically traded at a 5% to 10% premium.
Both Golub and Ares offer the potential for a rising income stream in a rising-rate environment. They also both offer a stable source of high-yield income on the cheap.
(For a smorgasbord of high-yielders you can count on all year long, click here.)