This article was first published to Systematic Income subscribers and free trials on September 3.
Welcome to another installment of our weekly BDC Market Review, where we discuss market activity in the Business Development Corporation (“BDC”) sector both from the bottom up – highlighting the people news and events – as well as top to bottom – providing insight into the wider market.
We also try to add historical context as well as relevant themes that seem to be driving the market or that investors should be aware of. This update covers the period up to the first week of September.
Be sure to check out our other weeklies – covering CEF as well as prime/baby bond markets for insights across the entire income space. Also see our introduction to the BDC industry, with a focus on how it compares to credit CEFs.
BDCs were under pressure this week with a 3% drop. This year, only the two months of March and July recorded gains in the sector.
The sector has returned about half of its recent recovery and is roughly where it was in early June after a big round trip. The year-to-date return is around -7%. This still puts it among the best in the revenue space.
The sector’s average valuation of 96% is around 6% lower than its historical average and is within the range of fair value in our view, given the broader macro dynamics.
Higher base rates are one of the key themes relevant to BDC’s industry. Given the dominance of floating rate assets, BDC’s net income will benefit from higher base rates, all other things being equal.
Many BDCs have already increased their dividends in expectation of higher net profit and some BDCs expect a significant increase in net profit during the third quarter. The average BDC is expected to see its net income jump 12% for a 1% rise in base rates from the end of the second quarter. Rates have already risen 0.8% from that level as the Fed continues its bid to rein in inflation.
Moreover, BDC’s second quarter net income figures do not even fully reflect the base rates at the end of the second quarter, as the higher rates only impact net income with a significant lag of about 3 to 6 months. For example, BXSL said on the call that its net income would have been 18% higher had its loans accrued at the end of the second quarter base rate level.
The evidence against this rosy scenario is simple – during the last up cycle, net income or core ROE actually fell, as this chart shows.
Repetition is clearly a risk and it should be emphasized. That said, we are a little more bullish as there are a number of key differences between this tightening round and the previous one.
First, the rise in base rates has been significantly higher and steeper in this cycle than in the previous cycle. Rates have already risen more than 3% (and are expected to continue to rise) from a 1.8% rise in the last cycle. As a proxy for base rates, the 3-month Treasury bill rate shows how the two cycles compare so far.
Second, we are starting at a significantly lower level of defaults, so there is lower initial income this time around due to defaults. Over the past cycle, default rates peaked in 2014 at around 4% due to distress in the energy/resource sector – more than 10 times higher than the current level.
Other concerns relate to tighter spreads, higher credit costs and lower leverage. BDCs who commented on the level of credit spreads universally said that the spreads are wider – that’s pretty much why NAVs fell in the second quarter. Credit costs are indeed higher, but the average BDC only has about half of its liabilities in floating format. Floating rate liabilities also represent about a quarter of its floating rate assets. And finally, leverage did not decrease significantly during the third quarter – in fact, it increased somewhat and not just due to a drop in NAVs, but due to an increase in net new investments.
Overall, we remain fairly optimistic about third quarter net income levels. We don’t expect BDC to see a double-digit increase, but a solid single-digit increase is not a crazy scenario.
BDC PSEC has finally announced its results (more information on the schedule in the next paragraph). Net asset value fell just over 3% – that’s a bigger drop than average and not too surprising for a portfolio that is higher beta in nature with significant exposure to CLO stocks and REITs. Basic net income (excluding preferred dividends) increased by a penny to $0.21.
PSEC does a big song and dance about how they manage a very low leverage portfolio and it’s true; however, there are two important points. First, there is more built-in leverage and cyclicality in the portfolio than for an average BDC due to holdings of CLO stocks and REITs.
And second, PSEC decided to use preferred stock for much of its financing versus debt. Only one other BDC – CGBD – does this and only for a small part of the financing which was done as a precautionary measure in 2020 with a subsidiary. This means that common stockholders must still pay dividends to preferred stockholders as they would to creditors, but at a higher dividend rate, which means less remains on common stock, all other things being equal.
PSEC focuses on net income which excludes preferred dividends which is fine – they can publish any number they want – but it’s a bit misleading since preferred dividends are a real cost to common stockholders . It’s also somewhat misleading, because the size of the privileged has increased, meaning that an increasingly large income outflow does not show up in their preferred version of net income.
PSEC had to delay its annual report and publication of its results due to a snafu in its CLO assessment reviews. Management expects to report a weakness in its internal controls over OCOL financial reporting. It seems that the problem itself has less to do with CLO marks in the wallet than with review procedures. At best, the CLO’s valuations are perfectly fine, but John Barry endorses them while playing pinochle on his iPad while floating in his pool. All in all, that’s probably not a big deal, especially given the low allocation to CLOs in the portfolio, but it doesn’t look great. The stock fell 6.5% on the news, but recovered some of it.