By Michael Foster
(Michael was under the weather yesterday but has made a remarkable recovery!)
Let’s start our retrospective with junk bonds. The SPDR Barclays High Yield Bond ETF (JNK: $37, 6% yield) ended the week mostly flat after going ex-dividend (17 cents each month) last Monday, showing another period of surprising restraint from a tightly-wound up market. Back in early 2016 when we were recommending junk bonds most aggressively, funds like this started a bull run that was steep and long lasting, hindered only by a correction at the end of the election cycle that reversed course shortly after Trump won. Junk bonds returned to their 52-week high by February, and since then have reversed course slightly. The market is about 2% off its recent high, with the correction happening mostly over the last month or so.
This is good news for the junk bond market because of two big pressures happening to the market. First is the yield spread issue. U.S. Treasury yields have been climbing higher although recently stalling, and yields on junk bonds needed to either go higher or stay where they were lest the spread between Treasury and junk bond yields get too small and thus disincentivize investors from buying junk bonds. Since bond yields and prices are inversely related, this meant junk bond prices had to go down a little or a lot. The market decided on a little, and spread the pain out over several weeks. This is a restrained move, indicating a market awareness that junk bonds can’t go up in price significantly, but there’s no justification for a crash either.
This conclusion is particularly surprising because of the second big pressure on the market: Retail. You may have read the news of Retail giants going bankrupt and closing stores. Go to your neighborhood mall and you’ll see it yourself. If you’re old enough to remember the mall’s heyday, going to one of these shopping centers today is cripplingly sad. But don’t feel bad for the retailers - feel bad for their creditors. Retail shops rely on junk bonds and middle market lenders to give them liquidity, so the crash in this market impacts the bond and debt markets too. Yet the intense store closings have done some damage to the bond market without causing them to implode like oil’s crash in 2014 did. This again indicates an awareness of building risks and a restrained response. It’s a laudable market response.
These kinds of risks should hit BDCs as well, which arguably are exposed to lower quality mall retailers. We’re still waiting for the bottom to fall out in the BDC universe. The UBS BDC ETF (BDCS: $24) was mostly flat this past week on little news, although we were disturbed to see insider selling at Main Street Capital Corporation (MAIN: $38), one of BMR’s former favorites. COO Jason Beauvais sold 4,300 shares, or 5% of his pre-sales stake, for six-figure proceeds. While share compensation meant he was a net buyer of stock, Beauvais’s sale of already-owned shares rings claxons in our ears, especially since Main Street still sells at its highest premium in history - a premium of 75%. That’s just too much for us no matter how attractive the stock is, and one can’t help but wonder if it’s too high for Beauvais too.
Triangle Capital Corporation (TCAP: $18.70) is another big BDC with a solid track record and insider selling. Director McComb Dunwoody sold 32% of his stake for $930,000 in cash. Of course, Triangle Capital is one of those paradoxes that portends safety with a steady portfolio of debts to reliable middle market companies. Not that that has resulted in reliable income to cover growing expenses, which is partly why the firm cut its dividend in 2016. That wasn’t enough reason for us to be cautious of the company back then, and there are fundamental strengths in the portfolio. But that’s not enough to justify buying in where dividend coverage remains uncertain. Dunwoody’s sale makes sense and, coupled with Beauvais’s, indicates something particularly distressing about BDCs: Insiders are getting less confident of the industry. This leads us to continue our caution about BDCs.
What’s more, we think investors need to try to understand what exactly BDCs are. They are an alternative investment, and that means risk. Alternative investments serve two purposes, both equally important. The first is to provide a diversified portfolio so that you get exposure to different asset classes in case one of those asset classes really does well one year. The other, arguably more common, raison d’etre for alternative investments is non-correlated returns. This is a complex concept but the basic idea is that you want to try to invest in things that don’t necessarily track your main equity investments, so in case that tanks you have something else going up while you wait for your main investments to recover.
The problem is that BDCs fail miserably on that measure for retail investors - their prime target investor group. Triangle Capital has a beta of 0.87 and Main Street has one of 1.1 - both suggest a close correlation to the S&P 500, versus the -0.38 beta of the iShares 20+ Year Treasury Bond Fund (TLT: $121), a fund that is truly non-correlated with the S&P 500. Investors get duped into BDCs because they think this isn’t correlated to the S&P 500 because it’s such a different kind of investment vehicle. That’s sadly not the case. That doesn’t mean this alternative investment should never be bought - it should, but only when it’s undervalued. And with massive premiums like Main Street’s, this is hardly an asset class that’s gone undervalued in recent months.
So what has? In all honesty, the most undervalued asset class right now may still be municipal bonds. We have been pounding the table on munis since December and we get more emphatic with this recommendation every week that we see the S&P 500 climb and junk bond values go higher. Muni bonds are one of the safest income producing asset classes on Earth, yet they’re priced as if they had a much higher risk than they really do. Yet the biggest risks facing munis - rate hikes in particular - are much bigger risks to BDCs and junk bonds, yet those asset classes are doing much better than munis. Why? Muni investors are an easily frightened bunch, and they’re still terrified about a rate hike that they don’t realize won’t hurt them. That makes for viciously underpriced bonds and a buyer’s market.
How to get into munis? Bull Market Report’s two picks - Invesco Municipal Trust (VKQ: $12.60) and Nuveen AMT-Free Fund (NVG: $14.78) - remain solid choices for getting into this market. You’re getting a near 6% tax free yield and we’ve already seen 4% capital gains since the start of December. There’s still room for these funds to climb as the risk-averse tiptoe back in. It’s a very easy cyclical price trend to follow, and we’re happy to ride it for the short term.