On September 18, 2019 the BDC Reporter attended an RIA & Family Office Forum, hosted by non-listed BDC Flat Rock Global and its parent Western Asset Management. We’ll have more on Flat Rock soon, as we intend to broaden our coverage to include “News, Views & Analysis” about the whole non-listed BDC sector – which has even less financial coverage than the 46 public BDCs in our universe. After all, today’s non-listed BDC could be public tomorrow and many asset managers control both, which provides insights about corporate governance; strategic choices and – most of all – credit underwriting. Flat Rock has two different non-listed BDC funds, with wildly different market niches and there are 37 non-listed funds in total out there, with $33bn in portfolio assets at fair market value, according to Advantage Data’s excellent record keeping. 

For the moment, though, we are recording some of the highlights from a presentation made by Michael Bazdarich, a senior economist at Western Asset Management who addressed the subject of fixed income and the economy from a 36,000 feet perspective and made a number of interesting points, which we jotted down in our notebook, and which might be of interest to our readers. As you’ll see below we’ve also sought to estimate what the implications might be for BDC investors should the views of Mr Bazdarich hold up.

Anyway, here are the key points made:

1. Yields are NOT at historically low levels.

Referring both to government and corporate data going back to the nineteenth century, bond yields are at “normal” levels. In fact, fixed income yield levels are in line with the landscape in the mid-1960’s (as well as many periods before), before inflation and rates shot up. That rise in inflation/yields was more the exception than the rule and inflation has now been declining for 30 years. Effectively very low rates as we have today is the real normal, and should be expected to continue as far as the economists eyes can see.

2. Recent economic growth is behind the historical average.

Over the long term term U.S. economic growth – even when we take into account recessionary years – is 3.75%. The current level of GDP expansion is 2.0% below the long term norm.

3. No recession on the cards

All economists hedge themselves on predicting the unpredictable. Mr Bazdarich was no exception, but generally argued that economic conditions are still favorable. He dismissed concerns that the ISM Manufacturing reading for August 2019 had dropped below 50 appears to presage – in the minds of some observers – an economic contraction. He bluntly said the report was “not worth looking at”.  As others have noted, he mentioned that consumer spending is strong and the yield curve is not really inverted and the Fed will ease in the future if need be to ensure that remains the case.

4. Trade War will not trigger recession.

The speaker pointed out that foreign trade was trending downward even before the Trump Administration began its ongoing “trade war”.  In fact – if my notes are correct – the trade balance has slightly improved of late. If there is to be an impact on the U.S. economy from trade conflicts, it’s more likely to come from knock on effects if Europe and other parts of the world decline because of tariffs, rather than due to the head to head America-China battle.

5. The Fed can’t do much if a recession does occur.

Mr Bazdarich was skeptical that if the economy did – after all – slip into a recession there was much the Fed would be able to do to affect how things play out. He argues that nominal GDP in the U.S. has been more stable in the last 10 years than at any other time in U.S. history, but that’s not due to the Fed, but to other factors.

6. Investment Grade Spreads Are Above Historical Levels

Although much has been made of late of the narrowing spreads between the risk-free rate and investment grade bonds, Mr Bazdarich indicated that BBBs are at 211 basis points, which is higher than the 165 bps historic average. That suggests spreads could narrow further in the short term.

Conclusion

At any time, tying broad economic thoughts to narrow  investment objectives is hard.  Nonetheless, we will try, on the assumption that Mr Bazdarich’s views are valid:

A. For BDC Fixed Income investors:  Debt investors worried that fixed income rates will increase in the foreseeable future; driven by inflation and GDP growth should be able to relax. Low fixed income yields are here to stay – and could go lower – which is a positive for existing holders of BDC unsecured debt, all of which is fixed rate.

B. For BDC investors generally: Common stock investors who had counted on higher floating rates to boost investment income should rethink. LIBOR has already dropped 0.5% this year and might drop lower, impacting investment income negatively and floating rate interest expense positively.

BDC loan spreads – already squeezed by competition – could narrow even further. That’s bad for common stockholders.

However, if no recession is on the horizon – and slow, steady growth in GDP is the most likely scenario ahead, that’s a positive for portfolio company EBITDA and earnings, with the latter benefiting from lower borrowing costs thanks to lower LIBOR and narrower spreads.

Should there be a recession after all, though, BDC investors should expect little tangible help from the Fed and any economic contraction might be worse than would otherwise be the case.

VIEWS

If True

Now it’s our turn…

As a backdrop for both BDC common stocks and unsecured debt, the picture Mr Bazdarich paints is relatively favorable.

Existing BDC fixed income investors would be the biggest beneficiaries as their investments would likely increase in value as rates dipped slightly more or even remained the same; and credit risks mitigated by EBITDA/earnings growth – even if modest – at underlying portfolio companies.

On the other hand, new BDC Fixed Income investors might find yields on new issues coming in ever lower and might bring the average segment yield – currently hanging on to a 6% per annum handle – materially lower.

When even the weakest BDCs are able to issue debt at sub-6.0% yields will the retail appetite for Baby Bonds continue or will those supposedly “yield hungry” investors move on to other parts of the debt market that meet their minimum return requirements ?

We don’t know but suspect there is a floor to be found where the public BDC Fixed Income market is concerned based on my conversations with investment bankers in the field.

Up And Down

BDC common stocks investors would be in a swings and roundabout situation:

Earnings would drop thanks to lower LIBOR and lower spreads but the volume of leveraged finance business and the credit quality of borrowers would increase – or at least hold steady -in a slow, but growing economy with a lower cost of debt capital.

Some companies with a major export component might be hurt by tariffs but a most would continue to motor on, supported by high government and consumer spending.

Market View

We’d describe this outlook as “same old, same old” and would leave BDC financial performance overall close to where this are today and have been for some time.

That seems to be the scenario which the BDC markets for both debt and equity appear to have adopted given the very modest volatility in prices over the past 6 months, and the slight incline we’ve witnessed in recent weeks.

We refer our Premium subscribers to our weekly Market Recaps for BDC common stocks and fixed income.

No Opinion

The BDC Reporter itself has no right to have any very considered views on the direction of the U.S. or global economy.

That’s way above our pay grade and not something we either the training or the chutzpah to attempt.

Mr Bazdarich could be right or could be wrong, but we will not be contradicting him.

Where We Stand

We’re a little more forthcoming about our big picture outlook for the BDC sector with which we spend every waking hour and have done for 15 years.

As we’ve been noting of late we’re concerned about developing negative credit trends, brought on by high leverage; a slowing economy in the last couple of quarters and the higher use of leverage brought on by the Small Business Credit Availability Act (“SBCAA”).

Even if we dodge a recession – and we pray for everyone’s sake that we will – we believe there’s a risk that BDC income and book value will be negatively impacted by higher credit losses.

Instead of the 2% sector growth in earnings per share in 2020 over 2019 being projected by the analysts, we’re concerned there could be a loss in the single or even double digits.

If we do “get” a recession, the numbers could be much worse.

We Are Not Alone

Interestingly – according to a recent Wall Street Journal article – there are similar concerns developing in the “junk bond” market.

Matt Wirz wrote on September 15:

Warning signals are starting to flash in the market for junk debt, an indicator that investors are worried that companies with high debt loads could be at risk even if the U.S. economy avoids recession.

Here are some bellwethers of the growing junk-debt anxiety.

By one key measure, the risk in the high-yield bond market is at its highest level since 2016, when a sharp slide in oil and natural-gas prices triggered a string of energy-sector defaults.

The U.S. distress ratio, which is the proportion of junk bonds that yield more than 10 percentage points above Treasurys, jumped to 9.4% in August this year from around 6% in July, according to data from S&P Global Ratings.

…

Default rates may remain low if easy monetary policy persists. But junk bonds and loans are also risky because they can suddenly drop from one credit-rating category to another due to declining earnings, rising debt loads or both, Mr. Eagan said.

“A lot of people think mostly about defaults and don’t realize the losses that can come from downgrades,” he said.

A steep decline in the price of loans with triple-C ratings—the lowest rung in the credit-ratings ladder—is a sign investment firms are preparing for more downgrades to the bottom category.

Most managers of mutual funds and collateralized loan obligations, or CLOs, have restrictions on how much triple-C debt they can hold. They typically jettison loans with the low rating when they expect more single-B loans to get cut to triple-C.

The selling triggered losses in triple-C-rated loans in August for the first time this year, counting price changes and interest payments. Meanwhile, safer loans with double-B ratings posted gains”.

Not Carved In Stone

For both the BDC and High Yield sector – which have more in common than many realize – these signs of trouble are at early stages, and could yet be reversed by economic conditions and/or lender action.

(Maybe we’ll have a lenders revolt and across the board demands for more covenants; tighter structures and lower leverage.

Maybe some lenders will shrink their ever expanding portfolios by raising their underwriting credit standards and saying no more often, causing compensation costs to drop but credit quality to improve

Maybe credit pigs will fly).

Nonetheless, after ten years of favorable credit markets, the risk to the downside is far greater than the benefit to the upside.

Infomercial

That makes vigilance – and these sort of ruminations – that more important.

We refer anyone interested in what’s happening on the ground where BDC credit performance in concerned to read the BDC Credit Reporter where just about every day we review what’s happening to under-performing BDC portfolio companies.

Even a casual perusal will show that there are plenty of credit hotspots to keep an eye on.

Keep An Eye On

We would suggest that readers spend less time on toting up what loans are non accrual (aka yesterday’s news) and focus on companies at the earliest stages of under-performing.

Those are reflected in lower quarterly valuations; changes in management;  new capital infusions; covenant (but not payment) defaults; loan maturity extensions; ratings changes and the like.

In our still incomplete database, we count over 260 under-performing companies and assets at cost in excess of $8.0bn.

To put that into context, that’s approximately one-twelfth of BDC portfolio companies and investment assets – both public and non listed.

Roughly 80% are still making their interest payments and are valued much more fully than their non-accruing counterparts.

That’s where the danger lies to BDC book value and earnings.

To make things even more complicated, there’s a wide dispersion in individual BDCs credit performance, requiring much drilling down into the data.

Ever More

Moreover, as we tick and tie and include every company in the BDC portfolio universe, we expect both the number of troubled companies and the associated portfolio assets to increase.

Our rough guess is that when we’re done with the IIQ 2019 results we’ll find that 10-15% of portfolio companies and a similar percentage of BDC assets at cost are somewhere on the credit distress scale.

We’ll keep readers up to date whether the U.S. economy zigs or zags.