BDC COMMON STOCKS

Week 16

Turning On A Dime

Talk about a reversal of fortune !

As late into the week as Thursday April 21, 2022 intra-day, the BDC sector was reaching a new 52 week high.

In this regard, we’re talking about the price movement of the UBS Exchange Traded Note which owns most BDC stocks and has the ticker BDCZ.

However, a similar phenomenon occurred at the only exchange traded fund which owns most BDC stocks and is sponsored by Van Eck and has the ticker BIZD.

At its height during the week BDCZ was up 2.2% and seemed likely to close the week even higher.

Powell Speaks !

Then Fed Chairman Powell spoke and everything changed. Here’s how Investor’s Business Daily explained what happened:

With inflation hitting levels not seen for decades, the Fed’s Powell has been growing increasingly hawkish on tackling the problem.

He used an International Monetary Fund panel discussion as an opportunity to give further signals on the interest rate hikes that lie ahead.

Powell signaled that a 50-basis point, or half percentage point, hike is likely when the FOMC meets next month.

He said it is “appropriate” that the central bank moves “a little more quickly” to raise rates than it has in the recent past. Powell also indicated that “there’s something in the idea of front-end-loading” in the removal of stimulus. “It’s absolutely essential to restore price stability,” Powell said.

Michael Larkin Investor’s Business Daily April 21, 2022

Impactful

In an instant, not only the BDC sector but all the major indices reacted unfavorably to the perceived increased “hawkishness” by the Fed.

The Dow Jones Industrial Average fell (1.75%) in the week and S&P 500 index ( 2.7%). Worst of all, the Nasdaq composite tumbled (3.8%).

BDCZ dropped less (1.24%) on the week, but (3.6%) from that intra-day record level of Thursday.

The S&P BDC Index – on a price only basis – fell (1.5%) for the week.

Not So Awful

Still, the Monday-Thursday upward price momentum kept the metrics that we look at weekly from looking too bad, if that’s any consolation.

Of the 45 BDCs we track, one-third still managed to end the week in the black (15) and two-thirds in the red (30).

Two BDCs increased by more than 3% in price over the 5 day period versus five than fell (3.0%) or more.

One BDC – Hercules Capital (HTGC) – even managed to reach a new 52 week price high.

As you can imagine that occurred just before the Fed Chairman spoke his truth.

Regular Metrics Review

The number of BDCs trading within 5% of their 52 week high – which had been creeping up for the past fortnight – fell back to 9 from 13.

The number of BDCs trading above their net book value per share – a favorite metric of many investors – fell, but only to 18 from 19.

All in all – while surprising at the time – the BDC price pullback of late Thursday and all Friday remained contained.

Logically Enough

This makes sense because the alleged 50 basis point increase in the Fed Funds rate in May – and the now expected 75 basis point bump expected by the markets in June – is actually a positive development for the BDC sector.

In just a few weeks, the Fed is now expected to raise the funding rate above the 1.0% level where most borrowers are protected by their “floors” and will now have to pay more for their floating rate borrowings to their lenders.

Very roughly speaking a 50 basis point increase will bring most BDCs to a break-even level in May and the expected 0.75% increase in June will begin to generate incremental interest income.

Second Half Benefit

Given that many borrowers fund themselves in 1 or 3 month increments, the actual re-pricing will likely occur in the third quarter, but that’s not very far away.

Beyond June, there are further increases expected – all of which will add to BDC investment income – and to borrowers debt service.

Short Term

We wouldn’t be surprised to see BDC prices move up again next week as investors begin to factor in with more urgency – and accuracy – the coming jump in profitability – courtesy of a Fed that sharply cut rates at the beginning of the pandemic and is now restoring them.

Countervailing

As we’ve discussed before, the possible brake on investor enthusiasm is that the Fed’s plans will be increasing the interest expense of leveraged borrowers by 25%-35%, depending on their starting point.

Ironically, well heeled larger borrowers catered to by BDCs like Bain Capital (BCSF); Ares Capital (ARCC); Owl Rock (ORCC) and FS KKR Capital (FSK) will see a higher percentage increase in their interest bill than smaller borrowers, already paying a higher yield.

All the BDCs will tell you that they’ve run the numbers even before committing themselves to their borrowers and there is plenty of room for leveraged companies to absorb these higher costs, but it’s not as simple as that.

There are many moving parts here, including changing input costs; wage levels; customer demand, etc. – all of which are in flux because of the unsettled global economic environment and made all the more problematic by the Fed’s harsh – albeit necessary actions.

There has to be collateral damage in this situation, and there will be.

Actions Have Consequences

Acquisitions planned will be placed on hold; expansions will be temporarily shelved; recapitalizations will be abandoned. New equity capital will be injected in some cases, especially where any problems being patched over are regarded as temporary in nature – as happened during the pandemic.

There will also be credit casualties, which will show up in our corner of the world as defaults and – typically – ultimately as restructurings conducted within or without bankruptcy courts.

Absorbable

Not to sound too cold blooded, but none of the above is necessarily a negative for BDCs – and their shareholders – over the long term.

Difficult market conditions mean many lenders pull back – including the syndicated markets – which could boost BDC loan spreads that have been eroding for years.

Even modest changes in loan arrangements for existing facilities leads to higher fees for lenders – finally back in a stronger position vis a vis borrowers.

There will be less new loan activity, but also less refinancing. As of the IVQ 2021, of 40 BDCs that we have the data for, 26 are within 90% of their maximum AUM size based on their latest equity and target debt to equity. These BDCs can maintain or increase their income even without adding a dollar to their portfolio size.

Step Into The Breach

When portfolio companies do get into trouble, their BDC lenders – more often than not as we’ve seen in recent years – have both the will and the resources to step in to rescue the businesses involved.

Unlike banks, BDCs – with their roots in private equity – are not shy about leading or participating in restructurings that involve taking minority or majority equity stakes in return for new capital and/or the reorganization of existing obligations.

If there are specialist “distressed” buyers hoping to benefit in the years ahead from credit problems at BDC portfolio companies, they will be disappointed. The BDCs themselves will be leading the charge except in the most egregious situations where the very raison d’etre of the troubled business is in question.

For BDC investors, this could well result in significant equity upsides whenever the U.S. economy “normalizes” again and those restructured companies are sold back into the market.

Fortresses

Thankfully, BDC balance sheets are as strong as they’ve ever been entering this period of turmoil and uncertainty.

This is largely to the fact that BDCs both large and small took advantage of the low rates and investor generosity in the unsecured debt markets in 2020-2021 – what we call the Great Refinancing.

Most BDCs are financed 50% or more (sometimes 100%) with medium term unsecured notes on attractive terms.

Practically speaking, this means that if loan values drop, there will not be a squeeze on availability as occurs when funding is principally based on secured revolving loan facilities, where values fluctuate.

Moreover – as noted many times before – the unsecured debt is fixed rate in nature and will not increase as the Fed pushes up floating rates.

When some BDC borrowers will be paying 10% or more for their loans, some of the BDCs themselves will still have debt on their own books priced at 3.0% or below.

Not Too Greedy

To their credit – all but a few BDCs – have also set themselves relatively reasonable maximum target leverage levels. The BDC rules allow debt to equity to go to 2:1. Yet, three quarters of BDCs (according to data we collect) have set themselves a maximum debt to equity on a regulatory basis of 1.25x or less.

In any future crisis in 2022-2023 – should one occur – we’re unlikely to see multiple BDCs desperately needing to reduce their balance sheets to meet regulatory or lending requirements or an upsurge in last minute Rights Offerings or the raising of unsecured debt (as occurred to a degree during the pandemic) as BDCs “fix’ their balance sheets.

All in all – and helped by much early signaling by the Fed – the current conditions for BDCs look immensely superior to the days just before and during the Great Recession.

Not Created Equal

Which is not to say that every BDC is equally well positioned. As always in what remains a highly diverse sector in terms of size, strategy, risk taking, financial management etc., there are likely to be a range of outcomes in the years ahead.

Coinciding with the upcoming BDC earnings season, the BDC Reporter – for its own edification and that of its readers – will rate every BDC from A to F on their prospects in the face of a potential recession. We’ll look at credit risk levels – both current and prospective – as well as balance sheet strength; debt maturities; likely liquidity and all the other factors that go into BDC performance.

Premium subscribers should look out for our new BDC Recessionary Outlook Table in the weeks ahead. As IQ 2022 results are received and reviewed, we’ll add a grade for each BDC player.

Divergence

Although we’re sanguine about the ability of the BDC sector as a whole to navigate a potential Fed-induced downturn we’re downright pessimistic about what might happen to BDC prices for a time should economic and financial conditions darken.

As we’ve noted before – and as we see in microcosm every time there’s a negative headline – BDC investors have proven themselves fair weather friends to the sector.

We don’t have to look very far back to be reminded how jumpy investors can be in the face of uncertainty.

BDCZ fell roughly (60%) in price within the space of a month in February-March 2020.

Will there be a similar failure of nerve in the months ahead ? It’s impossible to know, but the chances are relatively high. Historically, BDC price downturns of (10%) or more have occurred on average every two years. Maybe we’re due…

Summing Up

All this makes for a very interesting mix: BDC fundamentals are strong and are coming off seven quarters of growing NAV Per Share, earnings and dividends. The prospects for future EPS growth were already in the cards before the Fed started to raise rates and are only becoming stronger as the summer approaches, and at a faster pace than we – and most everyone else – expected just a few weeks ago. Credit results, too, are in great shape despite two years of breakneck lending amidst loose terms. BDC prices reflect all the above, and remain up YTD on a total return basis and still only (3.4%) off their highest level set just a few days ago.

YET, in its effort to break/brake inflation the Fed could very well trigger – and in a relatively short period – an economic contraction; record high short and long term rates and financial stress across the leveraged loan sector. This could cause those same BDC prices to go from a record high to a record low if sentiment changes drastically- also in a very short period of time. This could occur even though most of the BDC players involved are well prepared for most any eventuality and have been for some time.

“These are the times that try investors souls” – Apologies To Thomas Paine.

How this plays out – not only in 2022-2023 but also when the current crisis conditions dissipate in the years after – could make or break BDC investors who read the tea leaves the wrong way.

We think we know how this will all play out – both for the sector and the individual BDC players – but constant vigilance and re-assessment will be necessary not to be caught out by this unusual combination of conditions.

As always – through thick and through thin – the BDC Reporter will continue to review and assess market moving news – both at the company and market level – and bring you our conclusions.

There’s a lot at stake.