BDC FIXED INCOME

Shocked

The week ended March 20, 2020 was the most momentous in the short history of the BDC Fixed Income sector.

A segment of the unsecured debt market, studded with investment grade borrowers and accustomed to nearly nil volatility, fell apart on a price basis.

The median price of the 42 issues we track fell to $17.08.

That’s a monumental drop of (28.3%) in one week, and (32.8%) since two weeks ago when the median price was $25.40.

Neck And Neck

Incredibly, the price of BDC debt dropped as fast as that of BDC common stocks, which fell (28.4%) in the same 5 day period.

The week before – already one of the worst on record for BDC debt – the segment’s price decline was only one-third of stocks.

In fact, till two weeks ago, BDC Baby Bonds had dropped – in median price terms – only (1.4%) from their 2020 high point, while stocks were already in correction mode: off (11.1%). 

Not In The Game Plan

The BDC Reporter had warned in earlier Recaps that the BDC Fixed Income sector had shown in 2016 and 2018 a tendency to have its  prices drop sharply once overall market sentiment shifted to pessimism.

We didn’t expect BDC Fixed Income to remain untouched by the Covid-19 crisis.

However, both the violent drop in the markets generally and the extent of the price change which BDC Fixed Income endured were surprising.

That’s British understatement for the BDC Reporter being caught by surprise by this unprecedented price rout.

Everybody Involved

Almost as notable was how broad was the price retreat.

Just last week we had plenty of BDC Fixed Income issues trading above par.

In the weeks before that we were calculating just how many issues traded at $26.00 or above.

Quite a few.

This week, though, every single BDC Fixed Income instrument trades below book.

Way below.

Best Of The Worst

The highest priced issue is Hercule Capital’s (HTGC) Baby Bond with the ticker HCXZ, priced at just $22.00.

Over the last 52 weeks, HCXZ has traded as high as $27.36, 24% higher !

Down Low

Even worse for holders of BDC unsecured debt, some issues dropped to about 50% off par.

At the bottom of the BDC Fixed Income universe this week is Capitala Finance’s (CPTA) Convertible with the ticker CPTAG, priced at $12.40.

We used to worry when CPTAG – and many of its peers – dipped under $24.00 !

Why ? Oh Why ?

The obvious question is why would BDC unsecured debt prices drop so much.

Given that 38 issues out of 42 are trading at “distressed” prices (i.e. a discount greater than 20% of par) you’d think a vast re-think of the very viability of most BDCs as continuing concerns was underway.

After all, within the ranks of “distressed” BDC debt are the obligations of previously unimpeachable funds such as Capital Southwest (CSWC); New Mountain Finance (NMFC); WhiteHorse Finance (WHF); Gladstone Investment (GAIN) and so on.

They’re Still Standing

Admittedly the common stock share price of all of these “quality” BDCs – and the rest of the group – have been punished in price since the crisis began.

CSWC, for example, is off (54%). WHF is down (47%). 

Nonetheless, there’s no real sense in the market that either of these two BDCs is headed for the knackers yard: i.e. bankruptcy.

Yet, the debt of both BDCs trade as if all its equity were to be wiped out as well as a quarter of its debt.

Numbers Game

For that to happen – using the IVQ 2019 balance sheet of CSWC as a test case – its investment assets would have to endure about $370mn in losses from the level at year end.

Given that CSWC had $559mn of investment assets at FMV, that amounts to  writing off two-thirds of the portfolio.

We know these are unusual times, but given that CSWC’s aggregate net realized losses to date have been nil, that seems hard to compute.

Popular

Nor has anybody warned off the BDC’s Revolver lenders who – this week – increased their commitments to the BDC from $295mn to $325mn. 

A new lender was added to what is now an 11 bank lending group, and a facility that could yet be increased to $350mn.

The CFO of CSWC noted that the BDC – even in the midst of the crisis – had $200mn of availability at hand, by itself sufficient if need be to repay all unsecured debt outstanding. 

In fact, as we reported a few weeks ago – and before the current crisis – CSWC will be redeeming some of its last remaining Baby Bond (CSWCL) on April 3. 

The BDC won’t likely have to even draw on its Revolver as the  proceeds from two major portfolio company proceeds have recently been received.

Something Is Happening Here. 

All the above, especially for the bulk of BDC debt issuers, suggests that something else has been afoot in the past week besides a sudden existential dread about the collectibility of debt issued. 

According to multiple news reports and what we’ve heard from market participants, BDC debt got caught up in the general frenzy to turn assets to cash.

During the week market participants have been selling all but the kitchen sink in every asset category to generate cash – either to meet margin requirements or for peace of mind or to position themselves (there’s that FOMO thing again) for the “market opportunity” of a lifetime.

Ironically, amidst the greatest rout in asset prices in memory certain hedge fund titans have been tantalizing investors – via the financial news channels – with the prospect of the “greatest buying opportunity in a generation”. 

All of which may be true – and maybe made truer by the drastic drop in existing prices – but which contributed to this historic sell-off.

Relentless

Through the week, like in the stock market, every pause in the selling action was followed by a brief and tepid increase in BDC debt prices, followed by yet another step down to the levels you’ll see in the BDC Fixed Income Table for the week.

(We’ll be updating the Fixed Income Table shortly if for no other reason to illustrate what huge yields and price appreciation now exists in the BDC Fixed Income segment after years of stable, but modest returns). 

At some point – and that could be Monday – the “bargains” in the well known, well capitalized BDC names could draw back in a great deal of capital and push up individual prices and the median number that we discuss weekly. 

Against The Current

Much of what happens in the short run may have more to do with how the markets react to initiatives coming out of Washington D.C. and from hospital wards across the country.

There is great uncertainty about both how long the health crisis continues (June ? September ?) and how well the government handles the already necessary rescue effort. 

As we write this, Democrats and Republicans are stalled in the Senate, but that can change at any minute.

Strangely, the value of CSWC’s Baby Bond may be more dependent on a fiscal package out of our nation’s capital than any other factor. 

Back To Credit

However, there is no doubt that the current crisis – as discussed in the BDC Common Stock Market Recap – will have a negative impact on every public BDC to varying degrees.

An argument could be made – judging by where BDC common stock prices have gone – that some of the weaker BDC players – if we have a sufficiently terrible outcome in credit terms from this unfurling situation – might even be at risk of ‘going under”.

There’s never been a BDC bankruptcy and for good reason, but never say never.

Obviously, if a BDC should fail, there is the risk – a fortnight ago considered almost unthinkable – that its debt holders might not be repaid in full.

Maybe the big drops in BDC Baby Bond prices reflect some of those doubts ?

We assume that question will be on many readers minds and has been on that of the BDC Reporter.

When In Doubt: Analyze

So we looked at all BDCs whose common stock trades below $5.0 a share, which we’ll use as the threshold of potential concern about remaining in business.

We counted 15 names, or a third of the universe.

Of those, 10 have issued one or more public issues of unsecured debt.

The BDCS involved are MCC, TCRD,OXSQ,PNNT,ICMB,GECC,CPTA,MVC, HCAP and PSEC.

Formula

We painstakingly calculated – on a pro-forma basis using the latest numbers – how much the portfolio assets of each BDCs would have to be written off to be unable to repay all their debt obligations – including any publicly traded unsecured debt – in full.

Our comfort – and that of most BDC debt investors – has been that the low leverage BDC model ensures that even under-performing funds should have a surfeit of investment assets available to meet borrowing obligations in a worst case situation. 

This “liquidation analysis” continues to hold water even while the prospect of credit losses on a par with the Great Recession or more roil the market. 

Results

Our analysis concluded that – in a worst case – the weakest BDCs would have to write off between 50% and 66% of their investment assets before being unable to repay their debts in full.

Even MCC – trading for $0.45 as a common stock – would need to lose two-thirds of its assets to this treacherous market to not “cover” its debts.

Bonus

Furthermore, there are other factors that give us confidence even amongst the weaker BDC names.

First, there’s the ability of the BDCs to conserve cash by paying the bulk of its dividends in the form of additional stock.

GECC adopted that posture this week, which promises to generate cash that can be used to repay debt obligations.

Multiple 

Second, there are other sources of cash support that BDC managers can access,  if need be.

Over time we’ve seen BDC balance sheets propped up  by fee waivers of one kind or another and sometimes for many years. 

On other occasions BDC managers have injected in new equity capital at par,  or lessened debt obligations by buying back discounted secured or unsecured debt in the markets. 

Third, none of the BDCs involved have any unsecured debt coming due for repayment in the next 12 months, giving the managers plenty of them to restructure their balance sheets and to allow asset values to normalize.

As we’ve said in the BDC Common Stock Market Recap, time is the most important asset BDCs need at this stage.

Rich Relations

Fourth, many of the BDCs involved are either controlled by large asset managers who have a reputation to maintain or the fund may be of interest as an acquisition by some other deep pocketed buyer.

This provides other – albeit intangible – type of support to debt debt investors.

Committing

Of course, anything is possible in these trying times – but after adjusting for credit losses way in excess of any historic precedent and given the other mitigating factors, the chances of even one BDC failing to repay its unsecured debt still seems extremely low. 

If we’re right that will leave prospective BDC debt investors with some hard decisions to make.

After all, you can now invest in the lowest priced BDC fixed income instrument (CPTAG) and garner a 11.6% annual yield for the next two years plus and be able to generate a 100% plus capital gain when the convertible gets mandatorily redeemed in May 2022.

That’s either the “greatest buying opportunity in a generation” or fool’s gold. 

One Way Or Another

We’ll be very interested to see even by next week’s Recap which way market participants are leaning.