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2019-10-18 19:24:17

Introduction

Our goal is to present to you our IPO analysis for every new fixed-income security that enters the market and to find out if there is any trading potential. In this article, we want to shed light on the newest Baby Bond issued by OFS Capital (OFS). Even though the product may not be of interest to us and our financial objectives, it definitely is worth taking a look at.

The New Issue

Before we submerge into our brief analysis, here is a link to the 497 Filing by OFS Capital - the prospectus.

Source: SEC.gov

For a total of 2M notes issued, the total gross proceeds to the company are $50M. You can find some relevant information about the new baby bond in the table below:

Source: Author's spreadsheet

OFS Capital Corporation 5.95% Notes Due 2026 (NASDAQ: OFSSI) pays a fixed interest at a rate of 5.95%. The new issue has no Standard & Poor's rating but is expected to be rated BBB+ by the less authoritative Egan-Jones Ratings Company. OFSSI is callable as of 10/31/2021 and is maturing on 10/31/2026. The newly issued baby bond is currently trading at a price of $24.80, which means it has a 6.43% Yield-to-Call and 6.11% Yield-to-Maturity. The interest paid by this baby bond is not eligible for the preferential 15% to 20% tax rate. This results in the qualified equivalent YTC and YTM sitting around 5.36% and 5.09%, respectively.

Here is the product's Yield-to-Call curve:

Source: Author's spreadsheet

The Company

OFS Capital Corporation (OFS Capital), incorporated on March 20, 2001, is an externally managed, closed-end, non-diversified management investment company. The Company's investment objective is to provide its shareholders with both current income and capital appreciation primarily through debt investments and equity investments. It focuses primarily on middle-market companies in the United States, including senior secured loans, including first-lien, second-lien and unitranche loans, as well as subordinated loans, and warrants and other minority equity securities. The Company may make investments directly or through OFS SBIC I, LP (SBIC I LP), its investment company subsidiary.

The Company focuses on investments in loans, in which OFS Advisor's investment professionals have expertise, including investments in first-lien, unitranche, second-lien, and mezzanine loans and, to a lesser extent, on warrants and other equity securities. The Company's debt and equity investment portfolio includes industries, such as aerospace and defense; banking, finance, insurance and real estate; capital equipment; construction and building; environmental industries; high tech industries; retail; services; telecommunications, and hotel, gaming and leisure. The Company's investment activities are managed by OFS Capital Management, LLC (OFS Advisor). OFS Advisor is responsible for sourcing potential investments, conducting research and diligence on potential investments and equity sponsors, analyzing investment opportunities, structuring its investments and monitoring its investments and portfolio companies on an ongoing basis. As part of the portfolio management process, OFS Advisor performs ongoing risk assessment on each of its investments and assigns each debt investment a credit rating based on OFS's internal ratings scale.

Source: Reuters.com | OFS Capital Corporation

Below you can see a price chart of the common stock, OFS:

Source: Tradingview.com

While the text above provides us with a stepping stone in terms of information about the fund, it means nothing without looking at some numbers:

Source: Cefdata.com

Capital Structure

Below, you can see a snapshot of OFS Capital's capital structure as of its quarterly report in June 2019. You can also see how the capital structure evolved historically.

Source: Morningstar.com | Company's Balance Sheet

As of Q2 2019, OFS had a total debt of $281.5M, and with the newly issued 2026 notes, the total debt of the company becomes $331.5M that is senior to the company's equity. This makes the Debt-to-Equity ratio at 1.91, meaning the company is a bit more leveraged as the market capitalization is not enough to cover all of its debt.

Furthermore, we also want to add one more ratio, the Earnings-to-Debt payments. One can use EBITDA instead of earnings, but we prefer to have our buffer in what is left to the common stockholder. The higher this ratio, the better. From the income statement, we can see the company had a net income of $8.17M for the TTM with $12.53M paid of interest expense. So, if we add the $2.97M yearly interest for OFSSI, we have a ratio of 0.52, which is also not very satisfactory after there is not enough buffer for the interest payments.

The OFS Capital Corp Family

There are 2 more outstanding baby bonds issued by OFS:

OFS Capital Corp 6.50% Notes due 10/31/2025 (OFSSZ)OFS Capital Corp 6.375% Notes due 4/30/2025 (OFSSL)

Source: Author's database

A better idea of the peer group yields can be found in the following bubble charts:

By Years-to-Maturity and Yield-to-Maturity

Source: Author's database

By Yield-to-Call and Yield-to-Maturity

Source: Author's database

If we compare the newly issued OFSSI with the rest of the company's issues, with a Yield-to-Worst of 6.16% (equal to its Yield-to-Maturity), the newly issued senior notes have an advantage over its older relatives by this indicator. OFSSZ has a Yield-to-Call, respectively YTW, of 5.57%, which is a 0.60% lower from the new IPO. However, it becomes callable in a year, and if it doesn't get redeemed, the possibility of getting a higher return will increase to a maximum of 6.48% (the Yield-to-Maturity) for a year less than OFSSI, which is also higher than OFSSI's YTM. As for OFSSL, it has a Yield-to-Worst of 4.64% (its Yield-to-Call), but with the current nominal yield spread between the L and the new I of 0.425%, it's not very likely to be called on its earliest call date. This means the maximum one could realize in OFSSL is its YTM of 6.34% (0.20% higher than OFSSI for a year less).

In addition, in the following chart, you can see a comparison between OFSSZ and OFSSL and the fixed-income securities benchmark, the iShares U.S. Preferred Stock (PFF). Despite the two baby bonds are a term, securities, maturing in 5 years, that predispose to less volatile behavior (as long as there is no increase in the credit risk), very similar behavior is observed during the mini-recession in the late of the last year and the rally thereafter.

Source: Tradingview.com

Sector Comparison

The image below contains all baby bonds that pay a fixed interest rate, with a par value of $25, and a positive Yield-to-Call in the Asset Management sector (according to Finviz.com). For a clearer view, the baby bonds, issued by MDLY (MDLQ and MDLX) are excluded because of their high volatility lately due to shareholders' concern about the potential merger of MCC, MDLY and Sierra Income Corp.

By Years-to-Maturity and Yield-to-Maturity

Source: Author's database

The higher the YTM is, the better the bond is, and in this case, as they all are trading close to and above their par value, it is actually their Yield-to-Best. The YTC is the Yield-to-Worst of the group. The only exceptions, actually, are the newly issued baby bond, GECCN, and CMFNL, which are the only to trade below their par value. To see how the Yield curve looks like, first, I'll exclude all callable securities.

Years-to-Call and Yield-to-Call

Source: Author's database

Fixed-Rated Baby Bonds

The next charts show a more global view of all baby bonds that trade on the national exchanges, pay a fixed distribution, and have stated maturity date of less than 10 years, with a positive YTC. Again, MDLY's baby bonds are excluded, along with AFHBL, where the situation is very severe.

By Years-to-Maturity and Yield-to-Maturity

Source: Author's database

By Yield-to-Call and Yield-to-Maturity

Source: Author's database

Business Development Companies

This section contains all securities, issued by a BDC that have a positive Yield-to-Call:

By Years-to-Maturity and Yield-to-Maturity

Source: Author's database

By Yield-to-Call and Yield-to-Maturity

Source: Author's database

Asset Coverage Ratio

The 1940 Act generally prohibits us from incurring indebtedness unless immediately after such borrowing we have an asset coverage for total borrowings of at least 200% (i.e., the amount of debt may not exceed 50% of the value of our assets). However, the SBCAA has modified the 1940 Act by allowing a BDC to increase the maximum amount of leverage it may incur from an asset coverage ratio of 200% to an asset coverage ratio of 150%, if certain requirements are met. Under the SBCAA, we are allowed to increase our leverage capacity if stockholders representing at least a majority of the votes cast, when quorum is met, approve a proposal to do so. If we receive stockholder approval, we would be allowed to increase our leverage capacity on the first day after such approval. Alternatively, the legislation allows a required majority (as defined in Section 57(O) of the 1940 Act) of our directors to approve an increase in our leverage capacity, and such approval would become effective after one year from the date of approval. In either case, we would be required to make certain disclosures on our website and in SEC filings regarding, among other things, the receipt of approval to increase our leverage, our leverage capacity and usage, and risks related to leverage.

Source: 497 Filing by OFS Capital

Use of Proceeds

We estimate that the net proceeds we will receive from the sale of the Notes will be approximately $48.1 million (or approximately $55.4 million if the underwriters exercise their over-allotment option in full) based on a public offering price of $25.00 per Note, after deducting the underwriting discount and commissions of $1,562,500 (or approximately $1,796,875 if the underwriters fully exercise their over-allotment option) payable by us and estimated offering expenses of approximately $300,000 payable by us. We may change the size of this offering based on demand and market conditions. We intend to use the net proceeds from this offering to fund investments in debt and equity securities in accordance with our investment objective and for other general corporate purposes. We also intend to use a portion of the net proceeds from this offering to repay outstanding indebtedness under the PWB Credit Facility. As of October 7, 2019, we had $45.8 million of indebtedness outstanding under the PWB Credit Facility, which bore interest at a rate of 5.25% as of such date. The PWB Credit Facility matures on February 28, 2021.

Source: 497 Filing by OFS Capital

Addition to the iShares U.S. Preferred Stock ETF

With the current market capitalization of only $50M, OFSSI cannot be an addition to the iShares U.S. Preferred Stock, which is important to us due to its influence on the behavior of all fixed-income securities. I'll just remind you about last year's rally in the fixed-income borne from the redemption of the two giants HSEA and HSEB and the released cash of over $600M used from PFF to buy more of the rest of its holdings.

Conclusion

As fixed-income traders, we follow every one preferred stock or baby bond, which is listed on the stock exchange. As such, OFSSI is no exception, and the homework we always do we share it with the public. It is not necessary for the IPO to be an arbitrage and a bargain but in many cases, the new security happens to be better than the ones already trading on the market.

The company's debt and interest payments coverage is not at its best as the company is slightly more leveraged. Although, we are talking about a BDC that needs coverage of at least 150% of gross assets less all liabilities and indebtedness not represented by senior securities, after each issuance of senior securities. The newly issued 2026 baby bond has the best YTW from the family but as regards the YTM, it gives the worst return. Moreover, with the current nominal yield spread between OFSSL and the new OFSSI of 0.425%, the 6.34% YTM seems more tempting for a year earlier maturity than I . With respect to the sector comparison, despite it is one of the lowest nominal yielders, with its relatives , it gives one of the best returns in the sector, as they are only lagging behind the RILY's securities. The situation is also similar with respect to the BDC securities, while it is positioned somewhere in the middle in regards to all fixed-rated babies .

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.


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