The Idea was first published to members of my marketplace service on the 20th of July 2022
The business development company (“BDC”) sector has been quite impressive in the past decade. The Alpha generated from financing businesses that banks refuse to credit has turned out to be a true cash cow. BDC companies have benefited from extremely high borrowing rates taking on some credit risk that they evaluate to be overstated. It has been impressive for so many years but we cannot close our eyes and accept this as a given for the future. It is way more likely for high yield to outperform when the federal reserve is in a bubble creation mode and risk-taking is pushed to extremes. As of today, it is obvious to any investor that risky assets bring risk not only in theory. This is supposed to shift investors to a more risk-adjusted approach when investing their money.
When we talk about the BDC sector, there is one company that is above all – Main Street Capital (NYSE:MAIN). It usually trades at the highest premium to book value.
The market consensus is that this is well justified. MAIN is internally managed, has the lowest operating expense, and is the usual outperformer in the sector. It will be hard to say anything negative about the company and the management, and this is not the point. But we will try to defend the thesis that at the moment the 3% 2026 Notes of the company present a better risk-adjusted opportunity.
MAIN’s business, valuation, financial data, and returns
The company invests primarily in the debt of lower middle market companies and middle market companies, The leverage is limited by regulations and MAIN keeps its leverage lower than its equity – 96% of NAV as per the last report. Management is internal, invests in its own common stock, and keeps the operating expense as low as 1.1% compared to 2.9% for the BDC group. The portfolio is well diversified among 190 companies with an average investment size of around $17 mln. As per the last report, only 3.1% of the companies at cost are on non-accrual. This accounts for only 0.6% of the overall portfolio’s fair value. The success of the business for investors is mostly seen in the following chart.
The total return is 857% since IPO back in 2007. This is around 15% annualized. The peer group is not doing bad at all either with around 13.6% annualized. Here we have to add that MAIN has earned its status of deserving a high premium in comparison to other BDC companies and part of the outperformance we see in the chart is due to the fact that MAIN has not been trading at such a premium at its IPO. If the peer group has seen their premium rise to 60%, their returns would not be worse than that of MAIN. It would be somewhat fairer to show the same chart with NAV returns but we know how financial markets work – show the best you can. In fact, the premium to NAV is real and it acts as a cushion for bondholders. A company that trades at a higher premium has easier access to equity financings. It is not even a question of deserved or not. The placebo effect may not be real for some and be quite real for others.
Balance sheet data
The assets are presented with their “weighted-annual effective yield”. To me, this number is very important because as shown in the total return graph, management does not love to underrepresent. I will be using these numbers to construct something that we will call: “normal expectations assets yield” (“NEAY”). Based on the numbers presented above, the weighted average NEAY is 9.64%.
The debt of the company brings an average yearly interest expense of 3.5%. Keeping in mind that the company has almost 50% of its assets financed by debt, this expense in relation to all assets is around 1.7%. Here you can see the bonds being priced by the market:
The bond of interest to us is the highest YTM one and it is the 3% 7/14/2026 one trading at 6.71% YTM. The Cusip is 56035LAE4.
The notes in question were issued on 01/12/2021 with a 3% nominal yield and a term of 5 years. The spread to treasuries at the time was 2.5%. The initial issue size was $300 mln. Later on, as per the last quarterly report:
in October 2021, Main Street issued an additional $200.0 million aggregate principal amount of the 3.00% Notes at an issue price of 101.741%.
The additional $200 mln were issued at a spread to 5-year treasuries lower than 2%. At the moment of writing the 5-year treasury is around 3% and the notes trade at around 6.7% yield to maturity. This is a spread of around 3.7%. Obviously, the risk premium has widened and one would expect the business to have worsened in the past year. When you look at MAIN common stock vs the overall market, you get quite the opposite impression:
On top of this, Fitch has just recently assigned an investment grade rating to the notes. Here is what the price/yield chart of the notes looks like:
If the yield is to move higher a further 1%, the price will drop around 3.5%. We do believe that the spread has widened to a point when it is more likely to narrow in relation to the treasury yield curve. If we just assume a 2.5% spread to treasuries we can expect a 3.5% capital gain to be added to our yield to hold if we decide to sell when this spread target is reached. If the spread narrows, one may prefer to be invested in the common stock again.
Comparing the alternatives
Now that we have all the data it is time to make the comparison. To make it a fair comparison we will have to “create” our own BDC portfolio using the bonds of MAIN as assets and Interactive Brokers margin rates as leverage. As for the leverage ratio, it is somewhat unfair to use the same leverage for the “BBB-” rated bond of MAIN vs the high-yield portfolio of the company but let’s give the common stock the benefit of the doubt and keep the leverage equal. To make calculations easier we will assume that we have $100 in equity and $100 in debt. Based on the data presented by MAIN we can assume that the Assets are expected to generate 9.64% with an interest expense of 1.75% and management fees of 1.1%. This brings the ROE to 13.58%. Since you cannot buy MAIN at book value the expected ROI based on market price falls to 8.49%:
The return of the MAIN bond is crystal clear: – 6.7% YTM for 4 years of holding until maturity. The leverage expense is somewhat variable depending on FED policy and the size of your IB account:
With interest rates expected to rise to as high as 3.75% and if we have an account size higher than $1mln, we can expect that our interest expense will be around 4% -4.5%. To make the calculation I will be using 4.5%. As for the management fee, it all depends on the reader. Pressing one button in your IB platform is something I value as $0 so the management fee in my model is 0%. And here is the comparison:
8.9% from the bond, and 8.5% from the common stock. Of course, this has a lot of conditionality. And to be honest I see all the conditions making the comparison shine even brighter in favor of the bond. Here are the main points to consider:
- Safety – The bond has a BBB- credit rating by S&P and recently by Fitch while the portfolio of MAIN has an average yield of 9.6% (guess the credit rating)
- Duration – The bond investment matures in 4 years and you receive Par at the maturity date. The common stock fluctuations when the common stock trades at a 60% premium can hurt your ROI
- There is no common stock return if the bond is not paid in full at maturity and this is not true in the other direction( Common goes to 0 if the bond goes to 0, while if common goes to 0 the bond may pretty well be redeemed)
- You can list your “MAIN bonds BDC wannabe structure” on the exchange and someone may eventually pay a 60% premium. Who knows.
What the bond is missing:
- No extra yield if held till maturity. 6.7% is all you get. The common stock may outperform (not that this is likely, but it can happen)
- There is no one loving the bond so much. It is just value without any hype whatsoever.
An investor has to always shift to the best available alternative. Luckily in the case of MAIN, it is choosing between two good alternatives. Usually, in life, it is always about not choosing the worst one. It is very rare that such a short-term bond with such a high credit rating will have a higher expected return in comparison to its strong-performing common stock.