BDC Market Weekly Review: Buy Rumor, Sell News Action In ARCC Earnings

Summary

• We take a look at the action in BDCs through the fourth week of March and highlight some of the key themes we are watching.
• BDCs had a great week with a 2% return, making March the strongest month year-to-date.
• We take a look at the odd behavior of ARCC in the lead up and post its recent quarterly earnings announcements.
• Our BDC holdings continue to perform well - with 4 of our 6 holdings in the top 8 performers year-to-date.
• Given the willingness of the Fed to overtighten to bring inflation under control, a protracted recession remains a key risk - we view more resilient BDCs as attractive in this scenario.
• I do much more than just articles at Systematic Income: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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This article was first released to Systematic Income subscribers and free trials on Mar. 25

Welcome to another installment of our BDC Market Weekly Review where we discuss market activity in the Business Development Company sector from both the bottom-up - highlighting individual news and events - as well as the top-down - providing an overview of the broader market.

We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the fourth week of March.

Be sure to check out our other Weeklies - covering the CEF as well as the preferreds/baby bond markets for perspectives across the broader income space. Also, have a look at our primer of the BDC sector with a focus on how it compares to credit CEFs.

Market Action

BDCs had a very strong week with a 2% total return, lagging only MLPs and Utilities with only three companies posting negative returns. Month-to-date, FDUS and TRIN remain in the lead on the back of strong earnings announcements and dividend hikes.

March is shaping up to be a decent month after the flat months of January and February. BDCs have mostly ignored the recent rise in Treasury yields - very likely due to the bounce-back in equities as well as the rise in short-term yields which are expected to boost BDC incomes over the coming quarters.

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Year-to-date, all of our BDC holdings are in the green so far, with 4 of our total 6 holdings coming in within the top 8 performers.

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With the earnings season behind us, it's interesting to take a look at the NAV return trend. Our expectation at the end of last year was for the NAV return trend to continue to decrease and this is indeed what we saw in Q4. That said, the average NAV still managed an above-1% increase for the quarter, generating about a third of the sector's total return for the period. Going forward, we expect this downward NAV return trend to continue. This is due to the recent weakness in broader risky assets and their impact on asset valuations as well as a reduced number of portfolio exit opportunities (via IPOs or M&A) and the knock-on reduction on prepayment fees.

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Market Themes

Investors who follow the BDC market fairly closely have probably noticed some unusual behavior in Ares Capital Corp (ARCC). The company's Q4 results were very strong - it delivered a total NAV return of 4.6% versus the sector average of 3.8% and median of 3.0% - continuing its history of outperformance. The company also increased its regular dividend and declared a special dividend as well.

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So, of course, the stock proceeded to fall sharply. The chart below shows the price of ARCC over the past year with the red lines showing quarterly results announcement dates. The arrow points to the most recent Q4 results announcement. This is not explained by any obvious broader market moves. While the recent market environment has been a challenging one, to say the least, the rest of the BDC sector has held up just fine year-to-date.

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Interestingly, over the past year the stock moved sharply lower after the announcement, each of which were pretty strong. So why are we seeing such odd behavior where the stock moves lower despite positive news?

A flippant answer would be that this is just an example of "buy the rumor, sell the news". The market has learned to expect strong results from ARCC and knows to preposition for it, dumping the stock after the news is released. The chart below shows that ARCC has delivered pretty consistent NAV growth over time with an average quarterly rise in the NAV of about 0.6% or around 2.5% annualized. This trend has been even stronger in the post-COVID period.

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If we look at historic price moves on announcement dates in the chart below, we see that the ARCC price has tended to get a bounce from generally positive results with the average and median daily return way in excess of what they should be in a perfectly efficient market (i.e. they should be pretty close to zero on those days). However, what the chart also shows is that these bounces have been more random and less reliable more recently.

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This technical dimension does seem a likely culprit for this odd behavior. However, a related reason this has happened is for the simple reason that the company's valuation has tended to rise quite sharply ahead of its announcement. Whenever this happens, it leaves much less margin of safety for investors even if the results are good.

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The key takeaway here for the broader CEF sector, and particularly for those BDCs that have shown consistent returns above their yields, is that, absent a run-up in valuation, picking up some more shares in a BDC like ARCC a few weeks or days prior to the results announcement is a very reasonable thing to do, both for more tactical and buy-and-hold investors. In large part, this is because the valuation will likely be slightly understated on average for those BDCs that have historically generated a steady increase in the NAV, offering an attractive entry point for a marginal allocation.

Market Commentary

Trinity Capital (TRIN) raised its dividend at the end of the previous week by 11% to $0.40 and declared a $0.15 supplemental dividend. That equates to an 11.15% total dividend yield based on the price as of this writing.

The company’s NII has only risen above $0.40 once in the last 7 quarters, so this is more a reflection of the company’s recent ability to generate unrealized gains.

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TRIN has one of the highest equity / warrant allocations (double the average BDC) which largely explains its strong NAV performance. We’ve seen a very similar dynamic in FDUS. It’s no coincidence that, in a period of strong public equity returns, FDUS and TRIN had two of the best Q4s in the sector with quarterly total NAV returns of 11.3% and 14.1%.

The Golub Capital BDC (GBDC) valuation has moved lower to a 98% valuation the other day before rising slightly to 99% as of this writing. GBDC valuation has lagged that of the broader sector over the last year or so though it has tended to stay above 100%. Over the previous few years, GBDC has tended to boast a higher valuation relative to the sector as the following chart also shows.

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GBDC is generally regarded as a boring higher-quality, low-equity allocation BDC. It also benefits from very low debt interest cost and a cheap management fee structure. Recent total NAV returns have been below the sector average – primarily due to the low equity allocation and low yield on assets (a likely indication of a stronger credit profile). NII has been growing steadily and coverage is north of 100%, which should allow them to lift the dividend in the medium term back to the pre-COVID level. Current valuation gap of near 10% is historically unusual and we expect this to close, particularly if the equity market remains weak. GBDC trades at an 8% dividend yield.

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Stance And Takeaways

The recent commentary by Chair Powell in favor of potential 50bp hikes (and their positive impact on BDC income levels) as well as the recovery in equity markets have continued to support the sector. The key question for the BDC sector is whether the Fed's acknowledgement of the inflation problem and their willingness to overtighten to solve it will lead to a recession. And while the BDC sector generally fared well over the brief 2020 recession, a more traditional extended recession could dent company revenues, particularly as they may also be squeezed on the other side by higher interest costs due to the rise in Libor - the base rate for most BDC loans. This may lead to higher non-accruals and ultimately portfolio losses in the sector. This protracted recession risk remains a key one to watch for investors in the sector.

For this reason, we think it makes sense for investors to hold some allocations to BDCs that are likely to remain more resilient through a downturn such as GBDC as well as OCSL, both attractive at sub-100% valuations or below $15.40 and $7.40 respectively.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of FDUS, OCSL, GBDC either through stock ownership, options, or other derivatives. 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.

Comments

[Cantfixstupid]

It is nice to see an author mention TRIN. I own TRIN and FDUS as well as PNNT and HTGC, so a good week. I used the drop in ARCC to add more but I couldn't see a good reason for it. Thanks for providing insight into that dip for ARCC. As always, a great, insightful article.

[RoseNose]

Thank you for the interesting take on the recent ARCC price changes. Glad to know it truly is still performing well. Its my largest BDC holding. I have 8 others to enjoy.... HY gives a nice $ kick to the Rose's Income Garden portfolio.

[KMR holder]

@ADS Analytics You state..."we think it makes sense for investors to hold some allocations to BDCs that are likely to remain more resilient through a downturn such as GBDC as well as OCSL, both attractive at sub-100% valuations or below $15.40 and $7.40 respectively.".
These are two BDCs with low equity exposure which lend to higher quality borrowers, so that makes some sense. My question to you is more general. If they are attractive below NAV, how attractive are they above NAV. I assume you mean attractive to buy and or hold below NAV as downside risk is less for them if the economy turns. I expect that they will be relatively safer than equity heavy BDCs even above NAV, but at what point would risk outweigh their value in the portfolio?
At what premium are they no longer worth holding?
OCSL has grown to close to 45% of my direct individual stock holdings, not to be confused with my total equity exposure though funds and indexes . Yesterday as its share price exceeded December's NAV, I trimmed the position slightly at $7.47. I plan to trim further at $7.60, and more near $8.00. I plan to add below the most recently announced NAV.

[ADS Analytics]

@KMR holder Yep very good question. You can think of it in relative terms to the overall sector i.e. so long as something remains cheap to the sector it's attractive. The risk here is that if the overall sector is expensive then something that's cheap to the sector can still be expensive in absolute terms.

Or you can think of it in absolute terms which is a more difficult question. Here, you'd want to think of at least 2 things : 1) the potential NII uplift from higher Libor over the next 2 years and 2) the potential impact of a recession if we have one over the same time frame on default rates. This way to think about it is more speculative but more important for longer-term returns. The answer here will also be different for different investors - those who are "through-the-cycle" investors and those who are more tactical will respond differently to the same data.

ADS

[KMR holder]

@ADS Analytics When I buy a stock, I look for high teens annual returns with little downside risk. Since my initial OCSL purchase in May 2018, it has exceeded my expectations, returning a 22.52% CAGR. I have been able to do much better trading around a growing core position.

Today I don't see a BDC which can be reliably expected to perform to that level going forward, so I have been in capital preservation mode with my BDC positions, which is almost entirely OCSL. I just exited a small FDUS position as it rose rapidly above NAV. Two weeks ago I reentered ARCC in a small way and plan to exit at a 15% premium. My gain in ARCC has been more than 8%.

I retain my large OCSL position today in part because I would classify it as a true bond substitute for my portfolio when it trades around NAV. When one looks at it dispassionately all it really is is a levered portfolio of floating rate debt managed by one of the world's most risk averse and skilled debt managers. At NAV or below I don't really consider it to be a stock.

I believe that holding a BDC such as OCSL or GBDC at or close to NAV should reliably provide investors an income stream close to their yield on NAV with little long term capital risk. If I were to treat them as stocks, I would demand much more, I don't believe one can expect that without them trading at significant discounts.

[Basil6]

@KMR holder Thanks for your comment. How do you track NAV so closely?

[Javelina]

I do not try to guess moves in ARCC stock. It has and will continue to be a long term holding for me. I consider this “BEST OF BREED” of BDCs to be the long term buy and hold of my portfolio. Good investing all.

[Income4ever aka Cyclenut]

@Javelina
Agree, Long MAIN as well, HRZN and looking to scoop up HTGC -$16.75

[Javelina]

@Income4ever aka Cyclenut: I agree. My second largest holding is MAIN!

[Antiquarian]

@Javelina Looking at the daily price of many stocks, one sees occasional evidence of a random walk. The balance of supply and demand for shares on a daily basis tends to be the reason. Often investors want to wait to purchase shares until they see a price decline. Similarly investors seeking to sell (but under no immediate pressure to sell) will often wait until the price goes up. Assuming a reasonable supply of stock for sale and a reasonable demand, the price of many stocks yo-yo. Check out XOM.

It follows that seeing these price swings, some investors engage in day trading. Some even make a profit utilizing that technique.

I've discovered that I'm no good at day trading. So, I buy for the long haul and for dividend income.

[Will104]

Got out of HRZN and have had a great run with TRIN

Tempted to take profits in TRIN - but probably will re-load ARKK puts as a hedge