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With Lending Tight, It's Time to Buy the Lenders: Searching for Alpha, June 2010

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Let’s face it – borrowing money is tough. Small and medium size businesses are paying more interest, and face much stricter underwriting guidelines, than at any time in the last twenty years.

There are several reasons for this reluctance to finance. According to a recent study by FrontPoint Partners, the U.S. economy has lost over $160 billion in cumulative leveraged loan capacity with the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch. This is significant reduction in the natural buyers of loans (which are traded like stocks among banks and other financial institutions). Combined with the recent economic malaise, the reduced demand for loans has made borrowing money an exercise in futility for all but the most stellar firms.

Even though the banks aren’t lending as freely, there are still folks with capital to put to work. Business development companies (BDCs) are publicly traded companies that provide financing, typically through mezzanine and senior debt, to small and mid-sized businesses. Structures like REITs, BDCs are exempt from corporate income tax as long as they pass along at least 90% of their income in the form of dividends.

The handful of BDCs that currently trade boast yields of over 10%, making them an excellent addition to any portfolio. And with borrowing costs at such high levels, it isn’t unusual for them to enjoy spreads as high as 12% on their loans.

One caveat about these companies is that they are required to maintain suitable equity-to-debt ratios. As a result, they must routinely issue additional shares as the debt portion of their balance sheets grow. But if the stock price exceeds the company’s net asset value–which is the case for Fifth Street Finance (FSC)–secondary offering can actually be accretive to their valuation.

I expect such names to remain attractive until other lenders enter the marketplace–which is likely to take some time, considering the reluctance of banks and other financial entities to open their coffers.

The Monthly Index Report for May 2010





S&P 500 Index*




Large-cap stocks




Large-cap stocks
Nasdaq Comp.*




Large-cap tech stocks
Russell 1000 Growth




Large-cap growth stocks
Russell 1000 Value




Large-cap value stocks
Russell 2000 Growth




Small-cap growth stocks
Russell 2000 Value




Small-cap value stocks




Europe, Australasia & Far East Index
Lehman Aggregate




U.S. Government Bonds
Lehman High Yield




High Yield Corporate Bonds
Calyon Financial Barclay Index**




Managed Futures
3-mo. Treasury Bill




All returns are estimates as of May 28, 2010. *Return numbers do not include dividends.

** Returns are estimates as of May 27, 2010.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at [email protected].


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