BDC COMMON STOCKS

Week 7

Edge Of War

Reluctantly the markets have begun to accept there’s a prospect of war breaking out in Eastern Europe.

Should a conflict occur, there’s no way to forecast in advance what the impact might be on business conditions stateside.

Casualty List

During the week, the S&P 500 dropped (1.58%) after falling (1.82%) the week before.

The BDC sector – as measured by the price performance of UBS sponsored exchange traded note BDCZ – has followed suit.

For a second week as well, BDCZ dropped in price: (0.35%) and (0.69%) the week before.

The Wilshire BDC Index, which measures the “total” return of the sector, also dropped (0.35%).

Up Then Down

Those tensions in the Ukraine have put an end for the moment to a “re-rally” in BDC prices that began on January 24, 2022 intra-day and lasted till February 8.

In very short order, from lowest to highest , BDCZ moved up 8.4%.

However, since the 8th of February – a period which roughly coincides with the Ukraine flare-up – BDCZ has dropped (2.1%).

For the moment BDC investors have set aside their barely concealed excitement that the prospect of higher short term rates will boost earnings – and sooner than previously anticipated.

A Case In Point

This week, Sixth Street Specialty Lending (TSLX) on its IVQ 2021 earnings conference call directly addressed its expectation of the timetable and impact of higher short term rates in very explicit terms:

Given interest rates are clearly top of mind for many of our constituents, I’d like to hit on the Fed’s latest guidance, specifically the expectation for the forward yield curve. At the time of our Q3 2021 earnings call in November last year, we didn’t expect reference rates to reach the average floor levels of our debt investments until Q4 of 2023. We now expect reference rates to return to our average floor level of 1.08% during Q2 of this year. Given that 98.9% of our debt investments are floating rate in nature and 53% of our portfolio is funded with equity, a rising rate environment provides an earnings tailwind for our business once we reach our average floors. 

To give an illustrative example of the impact once we reach our floors, assuming our balance sheet remains constant as of Q4 2021, for every 100 basis point increase in rates, we would expect approximately $0.14 per share of uplift to annual net interest income. Again, in a rising rate environment, the sooner rates rise through our floors, the sooner we will benefit from this positive asset sensitivity of our matched floating rate exposures. Conversely, to the extent expected rate rises take longer to reach our floors, we anticipate a potential negative impact to net interest income.

Sixth Street Specialty Lending – IVQ 2021 Conference Call February 18, 2022

Everybody Gets A Raise

That’s just one very explicit example amongst dozens of the potential benefits BDCs and their shareholders should incur from higher rates.

In fact, TSLX – due to its policy of swapping out its fixed rate unsecured borrowings for floating rate exposure – will benefit less than most of its peers as short term rates rise.

For the moment, though, that positive development for BDC earnings and valuations is taking a backseat while all eyes turn to Europe.

Current Status

At week’s end, though, the BDC sector remained relatively strong despite two weeks of sector price erosion.

The number of BDC stocks trading at or above net book value per share actually increased to 18 this week from 17, as a large dividend announcement out of Fidus Investment (FDUS) added that BDC to this august group.

The number of BDC stocks trading within 5% of their 52 week high dropped this week, but only from 14 to 13.

During the week – thanks to the announcement of good results and an increase in its dividend – one more BDC – PennantPark Investment (PNNT) – reached a new 52 week high.

Down Low

Admittedly, there are now 3 BDCs trading within 5% of their 52 week low price – a phenomenon we have not observed since 2020.

However, none of the under performers (Great Elm Capital, SLR Investment and SLR Senior Investment) are related to the geopolitical concerns, and don’t represent some sort of “canary in the coal mine” of a coming BDC slump.

Looking Good

In fact, as BDC earnings season grinds along – with about a quarter of the universe having already reported and a large number set to do so in the days ahead – fundamentals are looking good, as are 2022 prospects.

We’ve heard again and again from reporting BDCs that the IVQ of last year saw record levels of investment activity and that the prospects for business in 2022 are for nearly as much.

Credit conditions continue to improve and – even more importantly – very few (if any) new borrowers are being added to the under performers or non performers lists.

Liquidity is almost universally in tip top shape, as you’d expect after many quarters of an improving financial environment.

Investors favorite metrics – NAV Per Share and distributions per share – continue to mostly improve.

Even when NAV Per Share has dropped (as was the case with Capital Southwest and TSLX) the underlying reason is a larger than normal distribution rather than any financial weakness.

Summing Up

The BDC sector is sitting pretty two years after the pandemic, with earnings and stock prices seemingly poised to rise in 2022 and – perhaps – into 2023.

However, till the situation in Europe is clarified (which might impact the direction of interest rates and other factors that affect the BDC sector) investors seem to be in a holding pattern.