This article was first published to Systematic Income subscribers and free trials on May 11.
In this article, we provide an update for business development company (“BDC”) BlackRock TCP Capital Corp (NASDAQ: TCPC), currently trading at a dividend yield of 8.8% and a valuation of 96%. Year-to-date, the stock has performed well with a total return of +3.3%, outperforming the sector by 7.5%.
We have held the stocks in our high income portfolio since November of last year. TCPC has performed well since then, generating a positive total return despite the significant market volatility we have seen over the past few months.
With the valuation converging towards the sector median level, we see less room for strong outperformance and are changing our rating from ‘Buy’ to ‘Hold’.
Total investment income rose about 6.5%, mainly due to a jump in interest income – a reversal of the decline seen in the previous quarter.
Net income increased 12% from Q4 and 6% from Q3, driven by a continued decline in interest expense.
The company maintained the same dividend despite coverage reaching 114%.
TCPC has a fetish for covering its dividend – they have done so for every quarter for the past 10 years. The obvious cost of this behavior is that they will tend to lower the dividend whenever the hedge gets too low, as they did in Q3-20 (red bars in the dividend and income chart above) .
Net asset value fell 0.6% due to lower ratings resulting from widening spreads during the quarter, not far off an average decline of 0.3% in the sector.
This appears as unrealized losses in the NAV bridge below. In other words, there are no systemic realized losses in the portfolio causing the net asset value to fall.
Given the rise in credit spreads since the start of the first quarter, we expect a further decline of 1-2% in net asset value so far in the second quarter, all other things being equal.
Net investment fell slightly in the first quarter as outflows outpaced new financing. This will lead to a slight decline in net income in the second quarter, all other things being equal.
Leverage was roughly stable in the prior quarter. GAAP leverage is at the upper end of its range, although net regulatory leverage is not particularly high. GAAP leverage is a better reflection of economic leverage, and this metric is about 0.2x the industry average. Although TCPC does not have an explicit leverage target, this suggests that we probably should not expect significant positive net investments over the next few quarters, particularly if NAV remains under pressure from the widening credit spreads.
The portfolio’s yield declined, although it was more than offset by a sharp drop in the company’s interest expense.
This decline in interest expense is due to the redemption of $175 million of 2022 convertible bonds. The company had to pay compensation of approximately $0.11 or approximately 0.8% of net asset value to redeem the bond before maturity, however, if she had waited until maturity to refinance the bond, she would have had to pay 2-3 times the mark. -total amount over the life of the bond in higher interest payments if it elected to refinance in 2022.
His tap of the existing 2026 bond at a yield of 2.475% is now well below the yield on US Treasuries of similar maturity. As the arrow below shows, the tap moment was exquisite.
This ultra-low coupon issue, along with the company’s investment grade rating, has enabled it to achieve one of the lowest debt interest charges in the industry. Its low level of spending is actually underestimated due to its low amount of floating rate debt at only 15% compared to 40% for the industry average (floating rate debt is generally at a lower rate than floating rate debt). unsecured fixed rate as it is normally secured and benefits from the fact that LIBOR has been and remains low relative to the rest of the yield curve). TCPC’s interest expense advantage will further increase as LIBOR increases through the remainder of 2022, given its large fixed rate debt footprint.
This combination of somewhat high leverage, an above average level of floating rate assets and a below average level of floating rate debt puts TCPC in one of the best positions for increase its income thanks to the continuous rise in short-term rates.
It’s also why TCPC is one of the few BDCs without a “revenue valley” or temporary drop in revenue due to rising rates. Indeed, its revenues have already benefited from the rise in short rates and will only accelerate from there.
Based on his statements, the company’s net profit will increase by nearly 4% when LIBOR hits 2% – LIBOR is already 40% of the way there and will likely hit 2% around August this year. And while we expect some spread compression to offset rising rates, current market volatility suggests that spread compression should be less than what we would normally see.
In terms of portfolio quality, non-accruals fell to 0.3% – a level that is a quarter of the industry average.
PIK revenues have returned to a low level that is about half of the industry average. Clearly, not all PIK income is “bad” or a prelude to moving to non-counting, but a high level of PIK income raises questions.
Management also specifically addressed its view of the portfolio in the context of both ongoing supply chain issues and persistent inflation:
On the portfolio, keep in mind that a lot of our portfolio is weighted towards service companies, software, professional services, financial services, we don’t have a lot of real risk supply chain exposure, although supply chain exposure can be a risk in the market. We see inflation, wage inflation and some good commodity prices, again, that don’t apply to us as a risk. But when we do our underwriting, we basically want to understand that these companies have pricing power. And we’ve seen this regular consistency that whether there’s wage inflation or some other type of inflation in cost of goods or operating expenses, the companies we’ve worked with have a good ability to pass it on in terms of price increases or other forms of income.
Total net asset value return in the first quarter was slightly below the industry average. TCPC has outperformed the broader industry in 6 of the past 8 quarters. The Q3-2021 underperformance was partly due to the full debt extinguishment payment highlighted above. This trend of outperformance is observable in the fact that the yellow line, which shows the relative performance of the last twelve months, is greater than zero. Between 2018 and 2020, TCPC underperformed by around 1% per year.
TCPC has generally kept pace with the industry – it has outperformed for the past 3 and 7 years and underperformed for the past 5 years.
TCPC remains among the most attractively valued BDCs that have generated a total net asset value return of 7-12% over the past 5 years.
We liked TCPC for the simple fact that it tended to trade at a significant discount to the broader sector, despite posting total NAV returns that were roughly in line or above the sector. This valuation differential has started to close recently, as the following chart shows, with the sector’s average valuation (orange line) approaching TCPC’s valuation (blue line).
We can best see this in the chart below, which plots the valuation differential against the sector. We initiated our initial position when the stock traded at a valuation more than 10% below the industry average. This has now compressed to around 5% below the industry average (and in line with the industry median), which we feel is more fairly assessed. For this reason, we have removed the “Buy” rating.
Take away food
TCPC achieved a good Q1, with a significant increase in net income and a drop in non-regularizations to a very low level. We expect a payout increase in the not-too-distant future, given the company’s high earnings beta to rising short-term rates. The stock has strongly outperformed the broader sector year-to-date, so much of that is, arguably, priced in, providing a lower margin of safety in our view. For this reason, we don’t see as much medium-term upside and therefore have a “Hold” rating on the stock.