Babson Capital Corporate Investors is an interesting high yield fund. With a focus on private debt, it resembles a business development company in some ways. Interested investors should note, however, that management is warning of distribution cuts ahead. Babson Capital Corporate Investors (NYSE: MCI ) is an interesting high-yield bond fund that invests primarily in private debt. There’s no doubt about it, this is a risky investment. And right now it might be even riskier than you think if income is your goal. Private debt MCI’s investment objective is to, “…provide a consistent yield while at the same time offering an opportunity for capital gains.” Although an odd wording, I read that to mean MCI looks to provide investors with a mixture of income and capital appreciation. It tries to reach these dual goals by investing in, “…privately placed, below-investment grade, long-term debt obligations of companies primarily domiciled in the U.S.” In other words, MCI buys high-yield debt from private companies or debt that isn’t traded freely in the public markets. That generally means the companies MCI is dealing with are small- to mid-size entities that either can’t tap the capital markets, or banks, for cash or don’t want to because the costs to do so would be too high. This can be a risky space to invest but also a very profitable one. In fact, in some ways, MCI is doing something similar to what business development companies do. As of the end of March, private debt made up around 60% of MCI’s portfolio. Along with the debt it buys, however, there are often warrants or other securities attached that either provide or can lead to owning equity in the issuing company. These are used as an incentive to do a deal since such securities provide some upside potential to investors. Thus, MCI’s portfolio also had about 17% of assets in private/restricted equity securities. The rest was mostly in cash or publicly traded high-yield bonds. On the surface this is an interesting way to tap into a market that investors simply can’t get at on their own. Although there are risks, since these are smaller and often lower quality companies, Babson is providing an experienced management team to help create a strong and diversified portfolio. So far, it’s done a solid job. Through the first half of 2015, MCI’s trailing annualized total returns over the one-, three-, five-, 10-, and 15-year periods are all above 10%. Those returns are based on net asset value, or NAV, and include the reinvestment of distributions. So, on aggregate, it’s hard to complain about the returns MCI has provided investors. However, before jumping in, you need to think about the purpose of owning this fund. Unsustainable? If you are looking at MCI for income, management’s comments in the March annual report should be concerning: “… it is likely that in 2015 we will have to reduce the dividend from the current $0.30 per share quarterly rate.” That $0.30 a share per quarter has been pretty consistent in recent years, why is it at risk now? The answer is two fold. First, according to management, “…net investment income is down due principally to the considerable reduction in the number of private debt securities in the portfolio resulting from the high level of exits and prepayment activity that has occurred over the last two years.” Second, and integrally related, high-yield debt markets are becoming less restrictive, allowing companies to issue public debt where they might otherwise have been pushed to work with MCI. This dynamic isn’t likely to change over the near term unless there is a severe market dislocation-in which case MCI’s NAV is likely to fall swiftly. Indeed, in a downturn the companies with which MCI works will be under stress and that fact won’t be lost on MCI shareholders. Sure, MCI may get more deals in a “bad” market, but it won’t feel good for MCI shareholders. This, then, is the big risk I see for income oriented investors in MCI. The CEF provides a yield of around 7.4%, but that may not be sustainable and there are other options with a similar yield that might expose you to less risk. If I was looking for income, I’d take a pass. But what about investors looking to get in on the private debt market? For such investors, MCI could still make a great deal of sense so long as income was a secondary consideration for you. In fact, even if MCI cuts its distribution, I wouldn’t expect it to be a massive haircut. A caveat or three There are three things to keep in mind here, however. First, MCI’s debt isn’t publicly traded so it has to price many of the securities it owns. There are guidelines for that, but there’s also a lot of leeway. If markets go south, it’s estimates of portfolio value could prove to have been overly optimistic. Second, even if its estimates are spot on, getting out of positions, especially in a difficult market environment, could be harder than you hope. Thus, it might be stuck in a bad holding with no place to go. Third, MCI has a history of trading at a premium to its NAV. Right now it’s a relatively low 3% or so, but that doesn’t change the fact that you are paying more than the portfolio is worth. The average premium over the trailing three years is around 13% and it’s been as high as 40%. So for investors looking to trade premiums and discounts, MCI should look enticing. But, if you buy CEFs because they allow you to buy assets for less than they are worth, MCI isn’t for you. Interesting, but… I took at look at MCI because a frequent reader requested it. I have to admit it’s an interesting CEF and I’m glad I did. If you own or are considering a business development company, or BDC, you should also look at MCI. That said, I don’t think it should be a core holding for most investors, but it could be a nice way to add a little spice to a diversified portfolio. Perhaps pushing some money that would otherwise go to high-yield debt into the CEF. But, based on management’s own warnings, the dividend isn’t sustainable right now. So, if you are looking for income to live off of, this is probably a bad option. Moreover, the nature of its holdings makes pricing an issue, particularly over short periods. So it would probably be best if you were willing to make a long-term commitment (say three to five years), unless all you care about are trading around premiums and discounts. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
