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BDC Fixed Income Market Recap: Week Ended April 13, 2018

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BDC FIXED INCOME

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The week ended April 13, 2018 was almost identical to the week before where BDC Fixed Income was concerned.

Last week the median price of the 35 issues that are actively traded was $25.32. This week, the median price was $25.33.

Also unchanged was the proportion of Fixed Income issues trading above their 50 Day Moving Average: about a third.

As before – and the case for several weeks now – no issue traded over $26.00.

This week, though, only 3 issues traded below par versus 4 last week and 5 the week before that.

We’ve seen the value of BDC Fixed Income debt affected by changes in medium and long term rates.

However, in the week just ended the 10 Year Treasury ended up just where it left off the week before.

Yawns All Around

Frankly, we’re  a little surprised that existing Note Holders have not been more spooked by the new lower asset coverage rules.

On paper that risks increasing the amount of debt loaded up onto BDC  balance sheets, increasing potential downside risks.

New Converts

This week even more BDCs flocked to sign up – figuratively speaking – to the new 150%  asset coverage of total debt rule.

New additions included GLAD, PFLT and GECC.

(We’re keeping a list which we’ll update and publish occasionally to keep track).

Asking Around

We remember asking the underwriters of PFLT‘s recent Unsecured Note offering in Israel a few months ago whether an increase in leverage might sour matters with investors.

The impression we received was that Israeli institutional holders would be spooked by this fundamental change in the rules of the game.

Moreover, years ago we met with a U.S. investment bank familiar with the Baby Bond market and asked a similar question.

(The BDC asset managers have been lobbying for this rule change for many years).

Again, our investment banker source projected market prices of existing BDC Fixed Income issues would fall out of bed on the news.

Also doubtful – in this investment banker’s view – was whether any new public debt issues might be sold without a significant premium should the higher leverage become the law of the land.

Undeterred

Yet, here we are several weeks after the Congress slipped the Small Business Credit Availability Act into law, and the markets seem to be unmoved.

Maybe the long fuse associated with the implementation of the new rules  – if only approved by the Board of Directors and not blessed by the shareholders – is one reason for the complacency.

Also, debt holders may be waiting around to hear more from the BDCs themselves or wait till there is any practical action taken before evinscing any concern.

We’ve shown in earlier articles that the benefit to BDC shareholders of the new law is likely to be minimal or non-existent.

Waiting Game

The BDC Reporter has not yet tackled what might happen to the risk profile of existing BDC Fixed Income issues when assets are piled on all paid for with additional debt.

Like Fitch Ratings – which in the week addressed the new reality in a press release – we’re waiting for greater clarity too.

Showing Our Hand

However our suspicion is that the credit quality of many BDCs will be degraded by the potential doubling of leverage.

The market, though, may not worry about such things until we get into the Next Crisis and we see what happens to BDC Fixed Income prices then.

Shaky

Back in early 2016 there was a slump in many BDC Fixed Income prices – sometimes by as much as 10% – last time markets were in a Major Panic.

Here is the chart of one of the 3 Gladstone Investment (GAIN) Term Preferred issues with the ticker GAINN.

As the chart shows, GAINN dropped sharply – even though GAIN itself was performing on a fundamental basis as well as the BDC has in many years at the time.

GAINN quickly recovered when the All-Clear sounded and went on to new heights.

Has To Be Said

Nonetheless the episode is a reminder that even BDC Fixed Income prices are not immune to investor panic and re-positioning.

Next time round – if the markets believe the risks have increased – it’s not unreasonable to worry that volatility – in this most stable corner of the financial markets – might increase.

Unfortunately no instrument is immune to market doubt.

A Mini History Lesson

The BDC Fixed Income segment is a recent phenomenon which essentially began back in 2012.

With one notable exception, no BDC public debt issue currently out there has been through the shaking and rattling associated with an economic recession.

That exception is the Ares Capital (ARCC) Baby Bond with the ticker AFC.

Inherited

Back in 2008-2009, AFC was the unsecured debt of the long gone and unlamented Allied Capital before being assumed by ARCC when one BDC giant bought another.

We have the benefit of hindsight and knowing that “all’s well that ends well”.

Shocking

AFC Note Holders at the time, though, did not have that advantage and as fears about an Allied Capital bankruptcy mounted in the Dark Days of the Great Recession, the price of the bond dropped.

And dropped. And dropped.

As this chart shows, AFC dropped from $25.00 par down to a lowest low of $3.640 !

Past Is Not Prologue

Of course that was Then, and this is Now and in the future conditions will be different from both.

We comfort ourselves with the notion that we’re unlikely to see another economic recession as virulent as the Great Recession  in our lifetime.

(But cannot help wondering: “What if we’re wrong ?”).

Worst Case

However combine an economic recession and potentially ever more leveraged up BDC balance sheets (both from the new law and the relentless use of the 30% basket for off balance sheet leverage) and we might get the same result.

Even an impact two-thirds less than what happened to AFC would shake BDC debt investors to the core – accustomed as they are for six years to tiny moves in price.

As with BDC common stocks, the Next Crisis/Recession will probably result in a shakeout with clear winners and losers.

BDC Fixed Income debt holders who’ve seen the entire sector trade within a $1 a share range from high to low might witness much greater discrepancies in prices and credit results.

Inequality

Identifying in advance which BDC Fixed Income issue is likely to sail through any storm and which might be damaged or dashed on the credit rocks is becoming ever more important with the leverage rules.

That’s why it will be interesting to see how Fitch and S&P rate the several bond issues currently in the market.

Will the ratings groups – not known to be infallible – acknowledge the higher risks coming down the pike thanks to the new law ?

Or will Note Holders of these investment grade issues get a nasty surprise in Year X ?

Even if the ratings groups fairly assess long term credit risk (and our view is that they’ve been leaning to an unduly optimistic standpoint even before the rules changed) what about all those other debt issues ?

No Coverage

By our count, less than a quarter of BDC Fixed Income issues have a public rating from one of the well known groups.

That leaves three-quarters unrated.

The BDC Reporter, though, has been undertaking – for its own investment purposes – Stress Test reviews of every BDC issue for years.

We’ll be publishing our analysis for readers in the future once the dust settles.

Truth Telling

Here’s a Spoiler Alert.

We rate every issue from A to F, with the former representing BDCs where asset coverage, after all Stress Test deductions are applied, is in excess of 400%.

An F rating applies when that asset coverage is – on a pro forma basis – under 100%.

Here’s the spoiler part: We’ve been surprised at how wide the dispersion of our internal ratings are considering how close BDC Fixed Income issues trade one to the other.

Not to be overly dramatic (even though that is our avowed style) but there’s a real possibility that some BDC Fixed Income issues might meet the Next Crisis head on and not result in full repayment to debt holders.

No debt investing is risk-free and BDC Fixed Income is no exception and risks being taken with debt holders capital varied widely between funds.

Of course – all that is in the unknowable future.

Right Here. Right Now.

In the week just past, though, the BDC Fixed Income universe – as reported here – added a new issue.

OFS Capital (OFS) issued and priced its first Baby Bond.

All the details – and much analysis besides – is in the article we wrote on the subject during the week.

The new issue has been listed in the BDC Fixed Income Table but is not yet actively traded.

We’ll let readers know when that occurs.

Three Dozen. And Counting

That brings back the number of publicly traded BDC debt issues of one kind or another to 36 and the number of issuers to 26.

With the new law, we may see many more Fixed Income offerings coming to market.

Some may wait till till next year, but some may strike now when rates are attractive and use proceeds to pay down Revolvers and wait to leverage up.

We imagine conference rooms around the country are filled with eager investment bankers and equally anxious BDC managers considering their next steps.

The OFS transaction was in the hopper long before the new law surprised everyone by getting enacted.

A few months from now we may see the first tangible outcomes of the new leverage regulations.

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