Welcome to another installment of our weekly BDC Market Review, where we discuss market activity in the business development companies sector both from the bottom up – highlighting individual news and events – as well as from top to bottom – offering an overview of 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 third week of April.
Be sure to check out our other weeklies – covering the CEF as well as the 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.
It was another tough week for the earnings space, and BDCs did not come out unscathed, returning around -1%.
Since the beginning of the year, about two thirds of the sector is in the green. Among the underperforming names are idiosyncratic names like Blackstone Secured Lending Fund (BXSL) (under pressure from lock-in expiries), Horizon Technology Finance (HRZN) (from a recent public offering), underperforming names like First Eagle Alternative Capital BDC, Inc. (FCRD) and Monroe Capital (MRCC), and higher valuation names like Capital Southwest (CSWC), TriplePoint Venture Growth (TPVG) and Main Street Capital (MAIN).
With BDC’s first quarter earnings season fast approaching, we expect the net asset value growth trend to continue to decline, under pressure from deteriorating valuations and lower prepayment charges in due to fewer portfolio company exits such as mergers and acquisitions and IPOs.
BDC’s valuations are at the meaty end of last year’s range. We don’t expect valuations to rise significantly above the current level, although we do consider adding a move lower towards 100%. Indeed, the sector’s net income should continue to grow in the short term, with the Fed now likely to act even faster than expected with, possibly, 2 hikes of 50 basis points in the short term.
One comment we’ve heard recently is that BDCs have been fully priced for the recent rise in short-term rates and their expected positive impact on income levels. Unfortunately, no evidence was presented for this statement.
It is true that certain market dynamics become fully priced very quickly, and this frequent behavior has given rise to the market adage “buy the rumour, sell the news”.
At the same time, many markets, such as commodities, are heavily impacted by the marginal impact of supply and demand as well as expectations that tend to dominate markets like equities. Thus, just because a certain expectation exists among certain market participants does not mean that the price of the given market variable will not be affected when the expectation comes true. The “market” is also far from being a monolith, with participants often having different views on a particular development. In short, the line between being an expectation and being fully integrated is less clear.
This week we try to assess whether the expected rise in BDC income levels due to the continued rise in short-term rates is really in the price or not. Specifically, should investors expect a further rally in the BDC market as higher short-term rates drive up BDC income levels, all other things being equal? For a refresher on the relationship between BDC earnings and short-term rates, take a look at our previous discussions here and here.
If we were to say that the expected rise in BDC income levels over the next few months is already in the price, we would point out two things. First, we will highlight the fact that BDCs appear to be deviating from the broader stock market, as shown in the following chart. This chart suggests that BDC’s performance was boosted by expectations of higher income levels and, in their absence, BDC would have fallen in line with equities.
Another perspective on the same dynamic is to highlight the fact that across the entire revenue space, the BDC sector has held up surprisingly well so far and is one of only three other revenue sectors in the green. This also suggests that BDCs are supported by expectations of higher income levels, otherwise we would expect BDCs to be in the red, especially given their higher beta profile.
Another reason to think that BDC’s revenue hikes are already in the price is that many BDCs actually raised their dividends very recently as part of their fourth quarter earnings releases, although it has to be said that the amount of recent increases does not cover the full extent of the expected increase in income.
However, if we wanted to argue that dividend hikes are not in the price, we would highlight the actual fourth quarter results and their impact on BDC’s prices. The typical pattern we have seen is for BDC prices to rally strongly on news of rising dividends. Arguably, if the expected dividend increases were already in the price, we wouldn’t have seen the price increases on the upsides.
For example, Fidus Investment (FDUS) rallied strongly following the recent increase in its dividend.
Just like Trinity Capital Inc. (TRIN).
And so does PennantPark Investment Corporation (PNNT).
Overall, it’s hard to say this information is conclusive, as a dividend hike also coincided with very strong overall earnings and NAV figures, which could have driven prices higher. And it’s also true that some companies haven’t reacted much to their dividend hikes, like ARCC and HTGC.
The correct answer to the question of whether BDC’s planned revenue and dividend increases are fully priced in is likely an in-between answer. Some of the upcoming income increases are likely factored in and some are not. In our view, it makes sense to watch valuations carefully, as higher-valued BDCs likely have less room to see price gains, as well as focus on BDCs with a higher income beta relative to BDCs. short-term rates, which vary from virtually zero to over 20%. Of course, it’s also important to keep an eye on some of the other quality factors since BDCs are total return vehicles.
Saratoga Investment Corp (SAR) is issuing up to $100 million of 6% 2027 bonds. These will trade on the exchange under the ticker SAT and will be used to refinance the 7.25% (SAK) bonds.
The median yield for the BDC baby bond sector is 5.4%, so at 6%, it’s worth looking at. The 6% coupon is one of BDC’s highest coupon bond issues in some time, and double what some other BDCs were able to achieve in 2021. A coupon this high is a function of two things: 5-year intermediate maturity, lack of big ratings from rating agencies (they have a BBB from Egan Jones for what it’s worth), and no luck on timing, given that 5-year Treasury yields are up 1.5% since the start of the year.
It’s no surprise that there were a ton of BDC bond issues in 2021, which almost completely dried up this year. SARs probably should have squeezed the ball and issued earlier when yields were lower, even at the cost of having to pay two bonds for 6 months, although they may have been limited by leverage or other considerations .
There are a few BDC portfolio updates leading up to the Q1 report. Horizon Technology Finance Corp. (HRZN) closed $73 million in new loans in the first quarter versus $12 million in prepayments. The amount of sales is unclear, but the net figure of $61 million seems very healthy. The average for the previous 3 quarters was less than half. They may not be counting actual funding, so the actual figure could be lower. However, if accurate, it is a good sign that BDCs may be able to find attractive opportunities to grow capital in this environment, with hopefully better returns.
We have also updated BDC insider trading in the BDC Investor Tool.
There have been quite a few sales of HTGC and MAIN, which may be related to zero-cost acquisitions around the same time (perhaps bonuses, stock acquisitions, or option exercises). Both companies are trading at fairly high valuations, so it’s no surprise that insiders are unwilling to continue to hold more shares at current levels.
Position and takeaways
Given the volatility and diminishing risk sentiment over the Q1 benchmark period, we wouldn’t be shocked to see negative earnings surprises. If we see significant setbacks in the BDC sector, we will consider increasing BDC’s allocation to the High Income portfolio as well as adding new holdings to the Basic Income portfolio. Indeed, the health of the corporate sector remains solid, with a low level of defaults expected in the medium term. Likely increases in income and dividends should also keep prices well supported.
We continue to like Carlyle Secured Lending (CGBD) (formerly TCG BDC), which trades at an 85% valuation and 11.17% total dividend yield, and BlackRock TCP Capital Corp (TCPC), which trades at a valuation of 97% and a dividend yield of 8.58%. (hedging for both is >100%), and would consider adding if valuations improve further.