This article was first released to Systematic Income subscribers and free trials on May 6.
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 first week of May.
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.
BDCs were up on the week despite nearly all income sectors finishing lower given the continued rise in Treasury yields and slightly lower stocks.
Year-to-date the sector is not far from a flat return. The underperformers have been idiosyncratic stories such as BXSL and HRZN due to lock-up expirations and additional stock offerings, historic underperformers such as FCRD and MRCC and higher-valuation BDCs that have been coming down to earth such as MAIN and CSWC.
This last theme is easier visualized in the chart below which plots the year-to-date total return (y-axis) vs. end-2021 valuation. The relationship is not perfect and a number of higher-valuation names such as HTGC remain at elevated valuations but the trendline is clear.
The valuation of the broader sector has continued to trade at the lower end of its range of the past year. We expect valuations to hold in relatively well, supported by higher dividend expectations, unless recession estimates increase substantially in the near term.
A key theme we have been discussing since the start of the year is the expected reversal of the previously strong NAV trajectory of the sector. As the chart below shows the average NAV has fallen over Q1. This was due primarily to higher credit spreads, a drop-off in fee income tailwinds and previously raised dividends in the sector which leave less room for retained earnings.
We expect further modest weakness in NAVs in Q2, all else equal, since credit spreads have widened so far in Q2 by a larger amount than they did in Q1.
Arguably, the biggest topic in the BDC space is the expectation of higher earnings on the back of the sharp rise in short-term rates. And while our base case is that net income will improve this year on the back of higher short-term rates we need to keep a few things in mind that might act as headwinds to this dynamic.
First, Q1 is very likely to deliver lower net income than Q4 due to origination seasonality and lower prepayment fees due to fewer exits (such as IPOs and M&A activity).
Secondly, the rise in Libor has not yet fully fed into BDC income. This is for two reasons. Libor started the Q1 income accrual period at just 0.22% and sped up towards the back end of the quarter. This means that most of the quarter witnessed a pretty low level of Libor. And two, Libor resets quarterly which means that over Q1, loans accrued the majority of their interest at a level of Libor that reset either in Q4 or in early Q1 when Libor was much lower than it is now.
Third, loan borrowers often have an option of whether to use the 1-month or 3-month Libor as the base rate for the loan which works to their advantage when there is a high differential between the two rates which can happen during periods of Fed rate rises that we are seeing right now.
Fourth, BDCs don't have floating-rate loans making up their entire portfolio but also have common shares and warrants in portfolio companies. These assets will not benefit from rising short-term rates.
Fifth, the rise in the loan base rate is typically accompanied by spread compression, particularly in a low-default environment such as the one we are having now. For instance, a loan at 3-month Libor + 7% when Libor is near zero may be renegotiated to 3-month Libor + 6% when Libor moves up to 1%. This is really a function of the fact that lenders are all-in yield investors i.e. they look at a loan on a total yield basis so if there is an increase in the overall yield level at the expense of a tighter spread they will typically be happy to get the refinancing done and call it a day rather than risk the borrower moving to a competitor. A saving grace here is that the current period is extremely unusual in that the base rate is rising in a period of weak markets and tremendous global uncertainty. This could keep spreads from compressing as much as they would normally. It could also keep prepayments limited so even if spreads do compress it may not necessarily pass through to BDC income because the portfolio turnover might be relatively low.
Sixth some weaker portfolio companies are likely to come under pressure from higher borrowing costs which could cause some portion of the portfolio to move to non-accrual and, possibly, be written down in expectation of losses. This is particularly the case for borrowers already vulnerable to higher cost pressures due to the recent rise in inflation.
Seventh, BDCs will not benefit from the full rise in Libor from 0.2% - its level at the start of the year. This is because most loans have Libor floors around 0.8-1%. This means that with Libor around 1.3% as of this writing only the 0.3-0.4% has actually filtered through net income levels.
One way to anticipate the move in income and dividends due to rising rates is simply to look back to the period of 2017-2019 when short-term rates rose very quickly on the back of the previous Fed hiking cycle.
Unfortunately, here the history is mixed.
Some BDCs hiked their dividends during this period such as ARCC.
while others cut such as FCRD.
If we try to aggregate the numbers, we get an average drop in dividends over the period.
This may seem odd but the period also coincided with a big energy shock where 20% of the Energy and Natural Resource sectors defaulted, making it difficult to separate the impact of the defaults and rate increases on BDC dividends.
We don't know what else will happen outside of the increases in the short-term rates. We could very well end up in a recession which would likely cause many BDCs to cut dividends.
In our view, the most likely scenario is that we get a decent boost in income over Q2 and Q3 which will then subside towards the back-end of the year as spread compression kicks in.
This week was a big one for Q1 BDC earnings releases. In this weekly we will only touch on a few details of some of the releases.
Carlyle Secured Lending (CGBD) announced very good results. NII rose 15% and the NAV rose over 1% - one of the largest gains so far.
CGBD returned 3.6% in total NAV terms which was 3x the average quarterly return so far and above the usual stalwarts like ARCC, TSLX and FDUS. However, this outperformance was magnified even further because of the stock's low valuation - its valuation is 17% below the sector average. CGBD trades at a 10.8% total dividend yield and remains with a "Buy" rating in the High Income Portfolio.
PennantPark (PNNT) increased its dividend to $0.145 from $0.14 which itself was an increase from $0.12 just in February. Net income fell but remained fairly high relative to the last couple of years. NAV fell around half a percent. First-lien allocation keeps increasing and is now at 55% from 44% in June-21 - a theme we have highlighted in the past. This will keep income growing while pushing the dividend higher. We also expect the rising dividend to push its valuation closer to the sector average over time. The stock remains "Buy" rated in the High Income Portfolio.
Oaktree Specialty Lending (OCSL) reported very good results. Dividend was increased again to $0.165 from $0.16. GAAP NII was 23% higher at $0.22 from $0.18 in Q4 and is by far the highest in the last couple of years.
As we suggested might happen earlier, the NAV fell about 1%. OCSL is quite conservative in how they mark their book – the loss is all unrealized (there was a small realized gain) due to wider spreads during the quarter. At this point the NAV is probably down another 1% as credit spreads have risen further, however, keep in mind this is all unrealized so would come right back if / when credit spreads reverse. Non-accruals are still at zero. OCSL remains in the High Income Portfolio.
This earnings season has highlighted a key differentiator between BDCs and public credit vehicles which is that, despite the much higher leverage level of BDCs versus credit CEFs, their NAV beta is very low. This allows BDCs to hold in relatively well in a reasonable market environment, though, naturally, prices can become extremely volatile during truly extreme market environments.
This tendency along with the likely positive uplift to BDC income from rising short-term rates which will begin to work itself through the sector in Q2-3 should allow investors to enjoy further dividend hikes beyond even what we have seen so far. Our six-name BDC holding has already enjoyed six dividend hikes in the last two quarters and we expect further good news on that front. At current valuations CGBD and PNNT remain attractive allocations in the sector.
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This article was written by
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Disclosure: I/we have a beneficial long position in the shares of CGBD, PNNT, OCSL 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.