6.5% Fixed Yield on Main Street Investment Grade Bond (NYSE:MAIN)

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Chunumunu

A Quick Introduction to Business Development Companies (“BDCs”)

Business Development Corporations (“BDCs”) invest shareholder capital in small and medium-sized privately held US companies. BDCs aim to generate income and capital gains when the companies they invest in are sold, much like venture capital or private equity funds. Someone can invest in BDCs, as they are public companies listed on major stock exchanges.

BDC Structure

BDC Buzz


BDC Investment Grade Bonds/Notes

Many BDCs offer investment grade (“IG”) bonds/notes for low-risk investors who don’t mind lower yields/returns. Thanks to the recent declines in fixed income, the traditional bond market is now offering excellent value, especially in the BDC sector, and I’ll talk about that over the next few weeks. However, many of these bonds are now bouncing and I have started buying shorter and medium maturities.

Traditional bonds do not trade on an exchange, but are available through your brokerage using CUSIP numbers with a face value/maturity of $1,000. These bonds pay interest semi-annually with a prorated interest payment on the date of purchase. Brokerages express trading prices as a percentage of face value. As shown below, MAIN’s 2026 bond is currently priced at $87.79, implying a present value of $877.90 for each bond. For more information on examples of bond trading using CUSIP and limit orders, please see the following link.

Most BDC bonds have credit ratings from Moody’s and/or S&P and so far no BDC has ever defaulted for the reasons discussed last week in:

  • Recession Resistant with Investment Grade Bonds

As shown below, BDCs are highly regulated with many protections for investors in common stocks and debt securities, such as the amount of leverage (asset coverage ratios discussed later), the asset diversification and having a portfolio that can “generate enough cash flow to pay interest as well as dividends to equity investors that are subordinate to debt holders”:

BDC regulations

Presentation of the ARCC


MAIN logo

MAIN

Investment Grade Bonds from MAIN Street Capital

Main Street Capital (NYSE: HAND) has three investment grade bonds (CUSIP: 56035LAE4, 56035LAD6, 56035LAC8) which are rated by S&P and Fitch at BBB- with a stable outlook reflecting:

Main Street’s portfolio focuses on investing in senior debt, strong portfolio diversification, strong credit and equity investment track record, above-average asset coverage cushion, performance operational consistency, an experienced management team and great funding flexibility with demonstrated access to public debt and equity markets.”

Source: Main Street Announces Investment Grade Rating (July 14, 2022)

MAIN Leverage

MAIN presentation


As discussed in the previously linked article, the “asset coverage ratio” is a financial metric that measures a company’s ability to service its debts by selling or liquidating its assets. The higher the asset coverage ratio, the more a company can cover its debt. Therefore, a company with a high asset coverage ratio is considered less risky than a company with a low asset coverage ratio. BDCs are required to maintain a minimum asset coverage of 150%, providing strong protection for bondholders, which is one of the reasons no publicly traded BDC has ever filed for bankruptcy or defaulted. to bondholders in the history of the sector.

As of March 31, 2022, MAIN’s asset coverage ratio was 227%, as shown below:

Coverage of PRINCIPAL assets

BDC Buzz

The “Interest Expense Coverage” ratio is used to see how well a company can pay interest on outstanding debt. Also known as the ratio multiplied by interest earned, this ratio is used by potential creditors and lenders to assess the risk of lending capital to a business. A higher coverage ratio is preferable, although the ideal ratio may vary by industry. When a company’s interest coverage ratio is only 1.5 times or less, its ability to meet interest charges may be in question.

MAIN’s interest expense coverage ratio has historically averaged approximately 4.0 times, as shown below:

PRINCIPAL interest coverage

BDC Buzz


Interest rate sensitivity refers to the variation in earnings that may result from changes in interest rates. As of March 31, 2022, approximately 73% of debt investments in MAIN’s portfolio bore interest at variable rates, of which 93% were subject to contractual minimum interest rates and only 19% of borrowings were also at variable rates. Chances are that many BDCs will increase their dividends over the next few quarters, especially as the Fed increase rates by another 75 points todayresulting in a significant improvement in this analysis for most BDCs

An additional element I wanted to address is the impact of rising interest rates. With the additional $500 million of low-cost fixed rate notes we issued in 2021, at the end of the first quarter, 81% of Main Street’s outstanding debt securities maintain fixed interest rates. This mitigates our exposure to higher interest charges in a rising interest rate environment. On the other hand, at the end of the first quarter, approximately 73% of our debt investments bear interest at variable rates, the majority being subject to contractual interest rate floors and with a weighted average decline of approximately 105 basis points. Therefore, future increases in interest rates will lead to increases in interest income, which will exceed increases in interest expense.”

Source: MAIN Investor Call

MAIN IRS

BDC Buzz


Current Common Stock and Bond Yields

In May 2022, MAIN reaffirmed its regular monthly dividend of $0.215 per share for the third quarter of 2022, plus an additional cash dividend of $0.075 per share.

MAIN Dividends

loyalty

MAIN is considered a “safer” BDC, which is why it has a below-average dividend yield, currently around 6.5%, compared to an average of around 7.3% over the past 5 years. However, MAIN’s dividend yield has trended lower, especially after excluding the March 2020 market disruption.

MAIN Yield

BDC Buzz

MAIN’s 2026 bond is trading at a significant discount, resulting in a yield to maturity of 6.5%, which is higher than the current dividend yield of its ordinary shares. Furthermore, over the next four years, this bond will slowly appreciate towards the face value of $1,000 and capital gains will account for a large portion of the yield at maturity, resulting in a lower tax liability.

MAIN remark

FINRA

The following chart and table are from BDC Google Sheets showing the obligations of MAIN. As mentioned earlier, I started buying shorter and medium duration bonds with relatively higher yields (for similar durations).

Over the next few weeks, I’ll be covering many more BDCs listed below, including their asset and interest expense coverage ratios:

BDC Notes

BDC Buzz


Conclusion – Risk Adjusted Returns

Given the uncertainty of future returns from stock/equity positions, I would suggest investors take this opportunity to lock in a 6.5% annualized return, at much lower risk, over the next four years. MAIN’s stock price is likely overbought at these levels and its Relative Strength Index (“RSI”) is currently at 70, which is generally a firm indicator:

IRS

loyalty

The main risk for the bondholder is a default of MAIN, which is extremely low given the history/performance of the company:

  • MAIN is a top BDC with a long track record of returns over previous market cycles
  • Debt asset coverage is 227% and by regulation must be at least 150%
  • Interest expense coverage has averaged around 4.0x, which is much higher than most companies
  • MAIN’s bonds are rated investment grade by S&P and Fitch
  • No publicly traded BDC has ever filed for bankruptcy or had any bad creditors in the history of the industry
  • A fixed yield of 6.5% for the next four years is attractive in an environment of high market volatility and yield uncertainty

Upcoming BDC reporting dates

BDCs have started reporting Q2 2022 results and I expect improved results from Q1 2022, including higher dividend coverage and maintained credit quality, but slightly lower NAVs (similar to Q1 2022) simply due to widening credit spreads (not related to credit quality). Chances are that many BDCs will increase their dividends, especially since the Fed will likely increase rates by another 75 points todayresulting in a significant improvement in Sensitivity to interest rates analysis for most BDCs (similar to previous quarter). This means that projected earnings for the third and fourth quarters will likely need to be increased. Additionally, most BDCs have been positioning themselves for a recession for some time now and COVID has provided a portfolio stress test that most BDCs have taken advantage of the market rebound to shift to more secure positions with a hedge of higher cash flow preparing for higher interest rates and/or an economic downturn/recession.

Over the next few weeks, I’ll be covering many more BDCs listed below, including their asset and interest expense coverage ratios:

BDC Q2 2022 Reports

BDC Buzz

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