Things aren’t going to script right now in the financial sector. It’s a widely established fact (based on years of historical evidence) that banks and other lenders typically prosper when interest rates are rising. In previous rate-tightening cycles, the financial sector was usually among the market’s top performers.
As I’ve discussed before in my High-Yield Investing premium newsletter, banks can feast in these conditions because the rates they charge borrowers on loans usually rise faster than the rates they pay to depositors. That widens net interest margins (NIMs) and fattens the bottom line.
Yet, the Financial Select Sector SPDR (NYSE: XLF) ETF has posted a negative return over the same time frame.
Well, there’s no single cut-and-dried answer.
But one likely reason for the sagging performance is the fact that short-term rates (which influence what banks pay on CDs and other interest-bearing instruments) have been rising even faster than long-term rates.
Since the beginning of the year, the yield on the 2-Year Treasury has climbed to 2.6% from 1.9%.
Short-term and long-term rates are currently separated by just 30 basis points (2.9% vs. 2.6%). In other words, the yield curve has flattened — not steepened. Some even point to the possibility it might become inverted, often a harbinger of recession (though that’s not a real concern at the moment).
Still, most analysts (myself included) remain steadfastly in the bullish camp for financial stocks, especially with a healthy economy supporting loan origination and timely repayments. In particular, we could be entering a favorable period for business development companies (BDCs), organizations that invest in and provide assistance to small- and medium-sized companies.
While not all created equal, those with conservative underwriting standards and improving credit quality could do well as demand for capital increases. And with the Fed telegraphing its plans, those like Main Street Capital (Nasdaq: MAIN) have had ample time to position their balance sheets accordingly in favor of variable rate loans and fixed rate borrowings. As a result, my High-Yield Investing readers and I are up nearly 50% on my original recommendation.
With all of this in mind, I recently ran a screen for publicly-traded BDCs currently sporting double-digit yields. I found four that are worth considering…
Remember that the stocks in the table above haven’t been fully researched and shouldn’t necessarily be considered official portfolio recommendations. I have an obligation to share my best picks first with my High-Yield Investing readers first. This screen is solely meant to uncover potential prospects that meet certain screening criteria.
That said, there are some interesting things to note about the stocks on this list.
Longtime High-Yield Investing readers might recall Prospect Capital (NYSE: PSEC), a former holding up until the November 2015 issue. The company was starting to show “a few question marks regarding portfolio quality and external fees” at the time, so I swapped it out for Main Street Capital. That upgrade has worked out well, as MAIN has since delivered a total return of nearly 50%, while PSEC has lost ground.
Prospect has shown improvement in some areas since then, but still has some work to do.
I am more comfortable with Oxford Square (Nasdaq: OXSQ). Formerly known as Technology Investment Capital Corp (TICC), Oxford Square provides capital to borrowers that need cash to pursue acquisitions or other growth opportunities. Like most BDCs, it works primarily with customers that don’t have ready access to traditional bank loans or lines of credit.
That means higher interest rates. As of last quarter, the firm’s loan portfolio was earning an average weighted yield of 9.9%. Net investment income totaled $8.7 million, or $0.17 per share. That’s an increase of 5% from a year ago, but still a bit shy of the $0.20 per share distribution — a shortfall that bears watching.
OXSQ doesn’t have quite the financial stability of MAIN, a risk that is reflected in the higher yield. But the firm’s equity investments hold promise. And the shares at $7.03 as of this writing are trading at an 8% discount to the $7.60 net asset value (NAV) of the portfolio. Management is taking advantage by investing aggressively in share buybacks, a smart and accretive use of capital given the discount.
The stock has already advanced 25% year-to-date, so the market likes what it sees. I am putting OXSQ on my watch list.
— Nathan Slaughter
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Source: Street Authority