Why It’s Time to Invest in Small-Cap Debt Securities

Current Financial Landscape for Small and Mid Cap Debt

In today’s financial context, small and mid cap debt instruments continue to be a hot topic among investors.
The yields on these assets maintain a positive alpha when compared to those issued by large-cap corporations.
This edge stems from the perceived higher risk associated with small-cap enterprises, even concerning senior debt instruments.

However, investing in this sector is not without its risks.
The behavior of global interest rates will be a crucial determinant in the following months, influencing both the yield and the overall value of these securities.

The Performance of Small Cap Markets

Recently, with expectations of a decline in Federal Reserve rates, previously elevated yields are now beginning to recalibrate.
Despite this, capital gains percentage remains relatively insignificant.

This trend is primarily due to the continued financial burden on many small businesses from high financing costs, despite interest rate softening.
Smaller companies generally have a higher dependency on debt compared to large caps, complicating their ability to thrive in high interest rate environments.

This struggle is evident within the performance of the Russell 2000, an index reflecting U.S.
small caps, which lags notably behind the more widely recognized S&P 500.

BlackRock’s Strategy in Small Cap Debt

BlackRock, the world’s largest asset manager, provides a fascinating example of a strategy focused on small-cap debt.
In 2012, it launched the BlackRock TCP Capital Corp (TCPC), which is particularly significant for those interested in small-cap debt offerings.
TCPC is a business development company (BDC) that primarily invests in the debt of lower-capitalized firms, often providing financing to businesses facing challenges in accessing traditional banking credit.

When it comes to U.S.
small-cap debt trading, TCPC is a pivotal reference point.
Following TCPC’s earning calls is essential for understanding BlackRock’s strategic decisions in this domain.
Recent earning calls have revealed notable data and insights into the portfolio’s performance and future outlook.

What If Interest Rates Decline?

If global interest rates were to decline, it is true that yields on debt securities could be impacted.
Most of TCPC’s debt investments are at variable rates, meaning a drop in rates could lead to reduced interest income from loans.
Thus, the yield on the company’s bonds might diminish if interest earnings decrease.

Nonetheless, recent earnings reports shed light on how BlackRock is navigating this challenging macroeconomic environment: TCPC’s debt-to-equity ratio has risen to 1.35x, compared to 1.17x the previous year, indicating an increased reliance on debt for investment financing.

Additionally, the company retains 97% of TCPC’s portfolio debt at variable rates, which has allowed it to achieve a weighted average yield of 13.7%, facilitated by rising interest rates.
Furthermore, the firm has chosen to increase its stake in non-performing assets, which represent 4.9% of the fair value.

Potential Scenarios Ahead

Despite the risk associated with reduced yields if interest rates fall, the price of debt securities could rise for several reasons.
Firstly, a decrease in rates would enhance the financial health of portfolio companies, lowering their financing costs.

Moreover, while a significant interest rate drop might lessen future yields, TCPC’s current dividend yield exceeds 13%, with forecasts suggesting it could reach 19%.
This indicates that the yield from debt instruments in the portfolio may continue to maintain a positive alpha when compared to those of large caps.
The high yield, although contingent on interest rate stability, suggests opportunities for additional capital gains.
If the market perceives increased stability from portfolio companies, bond prices could appreciate, generating capital gains for investors.