The article was first published for members of my Trade With Beta service on 8/21/2022.
I’ll start with this: The fixed income market is a complete mess. I have been trading this market every single day for the last 14 years and the events seen in the last 2 years are simply stunning. Fixed income gaps are across the country due to total lack of liquidity. Don’t take my word for it, try exchanging them and you will most likely agree. This creates many opportunities for greedy short sellers like myself, and the funny part is that it is extremely difficult to profit from mispricing. The income investor on the other hand is one who benefits greatly from the opportunity. There are so many wrong prices that it’s hard to choose what to present to the yield-hungry public, so I decided to share my third largest holding at the time of writing because it comes with a juicy yield of 7 % to maturity with an investment grade loan. evaluation. The investment in question is the HTGC bond dated 16.9.2026 2.625% of BDC Hercules Capital (NYSE: HTGC) with a CUSIP 427096AH5. This is a regular bond that trades in the bond market and is hopefully easy to find by the CUSIP number.
HTGC and its debt
To keep the article as short as possible and straight to the point, I will focus mostly on spreads. These are the regular bonds issued by HTGC in the last 5 years that have a 5-year term:
Before the Covid Panic of 2020, HTGC was able to issue 3 5-year bonds at a maximum spread of 2.89%. Then for a while in 2020 all credit spreads widened and the company had to issue at similar nominal yields, but the spreads went as high as 4.17%. Only a year later the company was able to issue at a margin of less than 2% on the 5-year treasury. The reason behind this could be that the bond issued in September 2021 was rated by Moody’s. This is a game changer overall. At the time of writing, the bond in question has a very large seller at 7% YTM while the 5-year Treasury is at 3.10%. Spreads are back to 2020 levels. Does this make sense is the question we are all asking ourselves? If I have to answer based on my financial understanding, I would definitely say that given all the recent financial and political data around the world, it is quite reasonable for credit spreads to widen. With this in mind, the reader should understand that the 7% YTM of bonds is not a once-in-a-lifetime opportunity that will make you sleep well at night and make you as rich as Elon Musk in a year. There is a good chance that the market price of this bond is correct. And here comes the headache. Why would anyone recommend an investment if it is priced fairly? The simple answer to this question is that no one currently has any idea what part of the market is fairly priced. If we assume that HTGC bonds have expanded relative to strong financial logic, we need to consider how credit spreads are behaving in other parts of the fixed income market.
HTGC has just been reviewed by Fitch and has received a BBB- rating.
Moody’s is also considering HTGC to be an investment grade issuer:
The public is suspicious of rating agencies, but in entities as simple as BDCs and closed-end funds, it should be pretty sure that the analysts whose professional job it is to rate creditworthiness are most likely giving a fair rating. The structure of BDCs is regulated by law and most BDCs are not even willing to leverage even though they are now allowed to take more leverage compared to CEFs.
Credit spreads on investment grade preferred stock
Here I have chosen to show the differences of 3 of the largest and most important preferred stock issuers BAC, FRC and PSA:
Actual differences for BAC are 0.3% lower than average, for FRC are 0.08% lower than average, and for PSA are 0.47% lower than average for the period examined. The picture is quite similar to any of the favorite high-quality stocks. None of them have expanded significantly at the moment and all are at least 0.4% lower compared to 2020 levels.
Credit spreads on investment grade debt swaps
Here I have selected the only comparable bonds and note that there are not many ETDs with 5-year maturities, so the benchmark here is again the 30-year Treasury:
On average, each bond from the list issued in 2020 narrowed its spread by 0.72%. So definitely the longer maturity investment categories have not widened their spreads on Treasuries and none of them are trading at the first spreads in 2020. This means that HTGC is as tough as the year 2020 because otherwise, the current bond price makes no sense at all.
How concerned is HTGC at the moment?
We just open our favorite site to see the feeling:
In addition to the dividend increase and 5 out of 7 articles being a buy recommendation, I have to remind you that the public pays $14.85 to own the common stock and that is 39% above book value. Since HTGC is a barebones BDC, this means that the public is so confident in the alpha generated by management that the public is paying the NAV very well to get this tasty 9.43% dividend yield. There is no way the market consensus is to pay a 40% premium, while the bond market consensus is to widen the credit spread to Covid levels. Something here is completely wrong.
HTGC Company Profile and a Hypothetical Proposal for Management
According to the latest report, the company has $2.87 billion in assets with $1.54 billion in debt and $1.3 billion in equity. Yield on assets is about 10%, fees and general and administrative expenses are about 2.2% and interest plus loan fees are 3.6% on debt and 1.9% of total assets. ROE is close to 12%. If everything holds still and there is no increase in non-performing loans, the company can be expected to generate 12% ROE. When HTGC trades at a premium of 40% to book value, one can expect to earn 8.5% on his investment in HTGC. Most of the debt that HTGC holds in its portfolio is so far from investment grade and yet, the company’s debt is investment grade. Now imagine for a second if the same management creates a simple CEF that invests in HTGC bonds at a yield of 7%. This CEF will most likely receive an A rating from any rating agency. The fund will be able to finance at much lower rates. Here is a simple calculation for HTGC management assuming they create a CEF term structure invested in their bond with interest expense on the fund’s A-rated preferred stock term of 4% and 1% in management fees:
Not bad for a leveraged investment in a BBB-rated bond. And if the market gets crazy enough and sells the hypothetical A-rated term preferred stock, they can do another CEF with it as an asset. All these scenarios are written for fun, but the simple calculations in them are financially sound contrary to the recent price of HTGC debt.
Fair value, duration and method of purchase of the bond
This is the link in question:
It does not trade on the stock market and one would have to be able to trade bonds in the bond market to trade it. I use Interactive Brokers to trade bonds and it is very simple as long as you have the permissions and print the Cusip number in the order entry window. There is still a big seller and this yield should not be missed. The bond price/yield chart looks like this:
If the bond is to fall to 8% YTM, its price must fall to 81.5% first. So with a 1% increase in yield, the price will fall by about 4%. This is what low duration means. To determine fair value I will only look at the performance of HCXY’s exchange traded debt which is a 6.25% note maturing in 11 years and trading above par. If HCXY trades at close to 6% YTM, then the 2026 notes have absolutely no reason to trade higher than 6%. Additionally, pre-Covid spreads that HTGC was issuing even before it was an investment grade issuer were around 2.8%. Since HTGC is now paying rating agencies to rate its debt and is a valid investment grade issuer, I personally see no reason for the bonds to trade at a higher spread than 2.8% on the 5-year. My personal fair value would be 2.3% on the 3-year Treasury which is currently higher than the 5-year. This brings my estimate of the bond’s fair value to a 5.5% YTM or an 89.5% premium. At a current price of 84.7% forward, this represents a capital gain potential of close to 6%. Any fixed income trader knows that’s crazy potential for a 4-year investment grade bond.
7% from an investment grade bond of a BDC trading at a 40% premium to NAV with 4 years to maturity that has widened its credit spread to Covid levels while all exchange traded fixed income is significantly narrowed is a must-have investment for any investor interested in maximizing their risk-adjusted returns. This price is not supposed to last unless the entire market is wrong and only this bond is priced fairly. This is a strange, strange market.