BANX: High Yield, Yet Conservative Outlook

ETFS

StoneCastle Financial Corp. (BANX) is a closed-end fund focused on the community banking sector across the US, with total assets of ~$165 million. StoneCastle Partners, the ultimate owner of the Fund’s manager manages BANX as part of a much broader community banking focused business with $17 billion in assets under management or advisement.

BANX’s investing strategy is unique enough to require a bit of background explanation. The community banking sector has some key differences from larger banks. They generally have simpler portfolios, with a large portion of residential and commercial loans in the nearby community. They depend a lot on local community knowledge and relationships. More than 20% of counties in the US have a community bank as their primary source of financing.

A well run community bank can earn a decent return with less of the macro black swan risk faced by larger banks with more complex operations. As the CEO said on the latest conference call, BANX is “primarily a pure-play on the domestic economy.” In contrast, most mid-cap and large-cap companies are more directly exposed to changes in geopolitics and international trade policy.

On the recent conference call, management discussed some of the advantages of the community banking sector (emphasis mine):

Well, the smaller banks have always enjoyed, en masse, better net interest margins than the larger banks because the customers of community banks don’t mind paying a little bit more for the same loan than customers of the larger banks, and that’s not an opinion, that’s a fact. Again, I always love quoting John Adams, “Facts are stubborn things.” FDIC gives all the data for every bank every quarter. So we can see that these smaller banks, while they have sort of a higher expense ratio because of their size, they can weather a little compression in NIM.

But they also have more pricing power in their local markets. Local customers are not walking away for 25 basis points. So they have more flex, and we’ve seen that more through StoneCastle deposit business at StoneCastle Partners. Obviously, we have deposits at over 850 institutions in all 50 states. So we see what’s happening in a very granular basis. And I have to say, banks are a little perplexed with this Fed decrease of how to handle it. Some banks are raising rates to try to do a land grab on deposits. Some banks are dropping a lot more than the 25 bps.

So it’s very interesting to see that they’re all testing to see how customers will react. But to your question and to keep it reasonably tight, I don’t foresee that the current economic policy or foreign trade issues, the yuan versus the dollar, it’s just – as always, and that “always” meaning decade after decade after decade, has a very little direct effect on community banks. Right. The hardware store, the borrower, the local manufacturer, it’s a domestic play. And while, yes, if the dollar strengthens, foreign goods become more expensive, and – but that’s sort of the tail, it’s not the dog. So historically, small banks are reasonably recession-resistant.

Portfolio

BANX invests in a lot of different parts of the capital structure: term loans and debt securities (~19% of portfolio), trust preferred securities (~14%), securitized credit, mainly the preferred shares in a CLO that its affiliate manages (~32%), pooled equity interests( ~15%), preferred stocks (19%), and common stock (~2%). It also has around 14% of the portfolio in a preferred stock index fund. Most community banks are privately held, not publicly traded.

Some BANX investing is done as part of regulatory capital relief transactions:

We are looking at regulatory capital relief transactions, which are typically issued by larger banks. These types of transactions provide credit enhancement against commercial loan portfolios, which result in banks lowering the risk-weighted assets on their balance sheet. To put this in better context, large banks that are subject to the restrictions of Basel III have 2 primary ways to improve their capital ratios, they can raise common equity or lower their risk-weighted assets. At this time, in particularly with the current volatility in the markets, bank equity valuations remain low and companies are less interested in issuing traditional common equity. However, while not novel, a useful tool for banks to lower risk-weighted assets, our regulatory capital relief transactions. These transactions typically pay attractive rates of return to purchasers. Yet the financial institutions cost is still cheaper than issuing traditional common equity at current market valuations. It is important to note that these are not off-the-shelf transaction….

Regulatory capital relief transactions are an interesting niche that most individual investors are unlikely to be able to source and underwrite themselves. Kaelyn Abrell at ArrowMark partners discussed the keys to successful regulatory capital relief transactions in an interview in Private Debt Investor.

The first key is sourcing. Relationships and experience in the asset class are obviously important. But banks also want to make sure there is two-way alignment with investors. The ideal partners have long-term investment horizons and no potential conflicts with a bank’s core businesses, among other characteristics. The second key is related to structuring and fundamental diligence of security terms, the collateral pool, and an issuer’s underwriting process. Investors need to have the ability to analyse all aspects of a potential transaction and evaluate tradeoffs between different terms and collateral. We discuss attractiveness of the asset class but issuer and security selection are of vital importance.

The final key is a flexible and opportunistic approach. The opportunity in regulatory capital relief evolves with the market environment, credit cycle, and regulations. In order to capitalise on the asset class’ long-term return potential, investors need the expertise and resources to pursue a variety of transactions types with differing underlying collateral.

StoneCastle’s Management has been investing in the community banking sector since 2004. The specialized and localized nature of this investing probably provides some competitive advantage.

One individual local bank may run into problems – say if it is a one factory town and that factory leaves. But a diversified portfolio of community banks provides far greater resilience. Within the US, BANX portfolio is highly diversified by geography.



Source

Since BANX invests a bit higher than common equity in bank capital structures, charge offs do need to get pretty large before they take a loss. Nationwide, credit quality in community banking sector is pretty decent. Non-current loans are only around 1%. A recent FDIC report shows this in a chart:



Source

BANX yields around 7%. There are a handful of BDCs that pay a similar rate, but with much messier portfolios. In order to get a yield similar to BANX elsewhere, an investor would probably need to take a lot more risk.

Long Run Performance

BANX has delivered the decent performance the past few years since it went public. Net investment income and distributions have both been trending up over time.



Source: SEC filings, author’s calculations

Can they keep this up? Let’s take a look at the latest earnings.

2019 Performance and Outlook

In the first half of 2019, BANX earned $0.76 per share in net investment income and paid out $0.76 in distributions per share. It also had unrealized gains in the portfolio totaling $0.37 per share. The few analysts that cover BANX were expecting slightly better total investment income for Q2, but the net investment income met expectations, and the stock still traded up after the announcement. The annualized yield of the portfolio as of the end of 2019Q2 was 9.16%. Management indicated on the latest conference call that they expect to cover distributions for the year. They currently have debt/assets ratio of 14%. As a regulated investment company (like all closed-end funds), it can lever up to 33% debt/assets.

As for the broader market, management’s conservative outlook stood out on the most recent conference call.

I mean, obviously, the markets are in complete disarray right now and not sure between a Fed decrease, credit spreads all over the place, hard to know where to go.

But we’re paid to be fiduciaries to look out for our investors’ best interest, and if that means having more dry powder in case of a correction occurs or finding interesting investments, that’s what where we’re here to do…

I talk to a lot of my peers running other vehicles in the industry and people who I look up to in terms of their view of the economy and the markets is, we are definitely really rounding the top of the credit cycle here. So putting a whole bunch of things on right now, as we said last quarter, it’s just not what we want to do when we are very comfortable being patient. It may not put the most management fees in our pocket, but as people have learned in six years, that’s not what we’re about. So we’re going to find the best things. And if we can’t find them, we’ll sit tight.

Overall, the portfolio is conservatively positioned. BANX is keeping some untapped borrowing capacity in order to take advantage of future opportunities.

In the event of an unexpected spike in interest rates (say a 1994 type shock) and/or a market meltdown, BANX would likely trade down drastically, at least temporarily. In the past few years traded at as low as a 33% discount to NAV. However, it hasn’t suffered any major portfolio write-downs. BANX has a prime spot on our list of stocks to keep buying in the event of global capital markets disruption. Given BANX is well managed and mostly covers its relatively high distributions, NAV is a pretty reasonable price to pay, especially for a yield focused investor.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BANX over 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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