Description

Hi, guys –

I'm back with another personal-account only fixed-income idea that's longer on narrative than actual credit analysis.

The Company:

SAQ is the ticker symbol for the baby bonds of Saratoga Investment Corp., a micrco-cap BDC that was ably written up by ele2996 back in 2012. Here's a quick summary of SAR from their latest 10Q, press release, and slide deck:

Assets: $300MM
SBIC Debentures: $103MM
Baby Bonds: $62MM
Net Assets: $128MM

Interest Income (annualized): $29MM
Interest Expense (annualized): $9.5MM
Interest Coverage: 3x
Available Liqiudity: $142MM

Non-Accruals: 0
Energy Exposure: 0%
Porfolio Leverage: 4.1x

I'm going to hand-wave away the SBIC assets and loans because I'm not 100% sure how they work. I do know that the loans are non-recourse to the company, and that they had to seek exemptive relief to avail themselves of the increased leverage afforded through the SBIC program – which is to say, they were able to convince their regulators that small business program was functionally equivalent to the Registered Investment Company 1:1 debt/assets ratio.

Here's a recent SeekingAlpha writeup recommending the common for a more in depth look as Saratoga:

http://seekingalpha.com/article/4021661-saratoga-investment-10-percent-yielding-conservative-bdc-increasing-dividends

The Issue:

The bonds were issued 5/31/2013, right in the middle of the taper-tantrum. They mature 5/31/2020 and have $0.47 quarterly coupon, for a 7.5% annual yield at par. The issue has been callable since 5/31/2016. At $25.08, SAQ is trading right at par + accrued interest.

The Appeal:

At the current price, SAQ is a low-risk, low-vol investment that offers an adequate return. If it weren't callable, I'd argue that it should be trading around $26.50, for a 5% yield to maturity, or a 4% spread to treasuries. But it is callable! And in fact is likely to be called in the near-term, Saratoga has put out a regristration statement for new bonds the proceeds of which will be used to retire the 2020s:

“We intend to use substantially all of the net proceeds from the sale of our securities to repay a portion of our 2020 Notes and for general corporate purposes.”

https://www.sec.gov/Archives/edgar/data/1377936/000119312516742698/d262597dn2.htm#toc262597_6

If it gets called, great! That's a 7.5% yield on what will have turned out to be a cash investment, which is incredible. If it doesn't get called, that'll be pretty much because everything went to hell, in which case I think SAQ will outperform the rest of the junk I own and would expect to hold it to maturity.

BDC debt is a lot safer than one might think. I'm not aware of any BDC debt holder suffering a loss through the financial crisis. GSC Capital, Saratoga's predecessor, came as close as anyone to stiffing their creditors, but even then:

"We used the net proceeds from the private sale of shares of our common stock and a portion of the funds available to us under the secured Credit Facility with Madison Capital Funding to pay the full amount of principal and accrued interest, including default interest, outstanding under our revolving securitized credit facility with Deutsche Bank AG, New York Branch. "

There are no guarantees in life, maybe things will be worse this time around. But even when BDCs run into problems, they tend to leak instead of blow up, if only because they have benefit of using stale quotes on Level III assets to value their book. And this thing only has three and a half years to run. At three years, well, “money good” would be too strong, but something like that.

I thought SAQ was a good deal when it was issued, bought some not long after, and have added more from time to time whenever it trades below par. Since issue, rates are down, spreads are unchanged, the company has made a lot of progress, and time to maturity has come from 7 to 3.5 years.

This is a low-vol investment because it's callable and thus just won't go up much. But it's not likely to go down much either, thanks to the hefty coupon and the short time to maturity. Like, if total return is 0% over the next 12 months, it'll be trading at an ~11% YTM, which will mean that the world isn't a good place but you still broke even. You're getting 7.5% in return for absorbing some tail risk. I'm not going to advise on portfolio construction, but you're worried about absolute returns and tail risk, you could buy some of this and use some or all of the interest to fund a put-buying program.

Caveats/Other Stuff

Liquidity is low. If that's a problem, well, sucks to be you!

This is a fixed-income investment and is thus extremely price sensitive, I'm likely to change my position significantly given an unmotivated move by 2% in one direction or the other.

A friend of mine went to college with the CEO. He didn't know him well, but remembers as being smart but an asshole. Which is fine!

Yours,
Bowd

Catalyst

Coupon.