The fear of higher interest rates has cast a shadow over the entire stock market. The Fed is set to begin the slow process of interest rate increases any day now.
Although it is an excellent signal for long-term economic improvement, investors are worried about the effect climbing rates will have on stocks.
The recent outsized volatility in the major stock market indexes was partially resulting from fears of the pending increase.
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While the entire market has suffered from these fears two sectors, in particular, have struggled the most.
These areas are particularly sensitive to interest rate increases. However, the fears have been greatly exaggerated and now is an ideal time to start adding these beat down names to your portfolio.
The sectors are business development companies BDCs and master limited partnerships MLPs.
Let’s take a closer look at each of these sectors then drill down into our top pick from each sector.
Business Development Companies
The best way to think of these companies is an alternative lender to business. When no one else will lend to small enterprises, the BDC sector will step in providing the much-needed cash for a deserving business.
These firms fill a niche left empty by traditional lending companies and banks. Unfortunately, many banks still refuse to lend to small businesses without perfect credit and other credentials. Despite the small business sector accounting for over 50% of sales and jobs in the United States. Also, the Small Business Confidence Index has been in a strong upward trend.
Fear of another financial crisis triggered by sketchy loans has forced banks to stick to tight lending standards regardless of the improved economy
Also, most mainstream banks still hold onerously high credit standards for small businesses. In fact, these credit standards are so high, many small businesses, even successful ones, are unable to obtain financing from traditional sources. These events have created the perfect environment for alternative business lenders such as BDC’s.
However, the spectre of higher rates has hurt the sector. You see as rates climb so does the sector’s cost of capital. Also, some firms in the BDC’s portfolio may default as rates increase resulting in losses.
The funny thing that I noticed is that the BDC sector is already trading as if interest rates have spiked substantially higher, and their portfolio holdings are defaulting!
Obviously, this is not the case. This fact has opened up an excellent opportunity for savvy investors.
BDC’s are currently boasting an average price to book value of $0.81. This translates into having a share price of just $0.81 for every dollar of real value. Add in the fact of an average dividend yield of nearly 13% and it paints a very compelling picture!
Master Limited Partnerships
Master limited partnerships or MLPs have also been adversely affected by climbing rates. However, the reaction has been way more severe than warranted. Here’s a refresher on MLPs.
An MLP is a type of limited partnership that is traded on the stock exchange.
There are two forms of partners in this partnership:
The limited partner is the person or group that providing the capital to the MLP and receives intermittent income distributions from the MLP’s cash stream, whereas the general partner is the party responsible for managing the MLP’s dealings and receives compensation that is correlated to the performance of the venture.
MLP’s are commonly used in the natural resource pipeline industries.
Many investors like to think of MLP’s as a toll road taking a small payment from each car that uses the road. In MLP’s case, the path is a pipeline, and the cars are the natural resources being transported. You see companies pay pipeline companies a fee to transport their products to distribution points.
MLP’s are known to be slow but steady large dividend payers. Investing in MLP’s is not a get rich quick scheme. It takes patience and a consistent pattern of dividend reinvestment to prosper with MLPs
However, remember, we buy MLP’s for their consistent income producing qualities. It’s much more important that the MLP steadily throws off dividends and is solid fundamentally than is a rapid climber.
This is why MLP’s have been having a terrible time in the face of climbing rates.
Most investors do not invest in MLP’s seeking growth. They do so for the quarterly dividends that average around 7% annually. MLPs are often collectively called “bond proxies” among professional investors.
As a substitute for bonds, MLPs prices are often connected to the price of bonds. It is the consequence of a rate increase on bonds that make many investors concerned about MLPs when rates start their slow grind higher.
When the Fed begins to raise rates, the bond market, led by Treasuries, will react. Market interest rates will climb together with pre-set rates, and for that to happen the price of bonds must fall.
While this is all true, the fact remains that MLP’s are primarily knocked lower due to the low commodity prices namely oil and gas. Oil and gas are lower thanks to the weak greenback, oversupply, and international economic troubles.
Many analysts firmly believe that the energy sector has bottomed or is very close to bottoming. When energy prices start to climb, MLPs will begin to gain ground regardless of interest rates ( within reason, of course).
Just like BDCs, MLPs are currently trading at levels reflecting high interest rates. It will take years of increases to reach the level needed to justify the average MLPs price. If history is any guide, the Fed is very slow at increasing rates. It is grinding, incremental process that can stop as soon as the economy starts to drag. Remember ,it is not an all or nothing process so the MLP negativity is severely overstated.
Our Favorite Business Development Company Right Now
We like Medley Capital (NYSE:MCC) as a buy right now. The company is presently trading at less than 70% of book value. That is a huge moat of safety around the shares currently. In addition, the company is currently throwing off a 14% annual yield.
Medley Capital Corporation is a closed-end, externally managed business development company (“BDC”) that trades on the New York Stock Exchange (NYSE: MCC).
Medley Capital Corporation’s investment objective is to generate current income and capital appreciation by lending to privately-held middle market companies, primarily through directly originated transactions, to help these companies expand their businesses, refinance and make acquisitions.
Its portfolio generally consists of senior secured first lien loans and senior secured second lien loans. In many of our investments, we receive warrants or other equity participation features, which we believe will increase the total investment returns.
Medley Capital Corporation is externally managed by MCC Advisors LLC, a subsidiary of Medley Management Inc. (NYSE: MDLY), whose experienced team of investment professionals maintains a broad network of relationships and has deep expertise in originating, structuring, executing and managing investments.
Our Favorite MLP Right Now
The number one MLP on our list right now is Enterprise Product Partners (NYSE:EPD).
Enterprise Products Partners L.P. is a provider of midstream energy services to producers and consumers of natural gas, natural gas liquids (NGLs), crude oil, petrochemicals and refined products.
The stock is down over 30% this year and is offering a yield of 5% plus. EDP’s fee based business keeps cash flow up as the company positions itself to profit from exports of NGL.
EPD boasts over $5 billion in annual EBITDA and a diverse group of assets. It is poised to ramp higher as the United States begins to export NGL
We firmly believe that the upside potential at the current level far outweighs the downside risk. However, nothing is certain in the stock market. Always use protective stops!