BDC COMMON STOCKS

Week 14

Back And Forth

This is a market that cannot decide itself.

After three weeks of strongly positive BDC results, which followed one week of much red ink, the sector slumped again.

BDCZ – the UBS Exchange Traded which owns most BDC stocks and has the longest history, dropped (0.43%).

The S&P BDC index – calculated on a total return basis – fell (1.1%), just after hitting a YTD record level – appropriately enough – on April Fool’s Day.

Opposite Week

The week before 39 individual BDCs were up and 6 were down.

This week was the exact opposite, with 39 BDC prices in the red and 6 in the black.

Cliff Diving

Moreover, there were plenty of sharp price drops, including 9 greater than (3.0%).

Most hurt was Cion Investment (CION), which fell (13.3%).

This followed – to underscore our comment about an indecisive market – a period when CION moved up sharply, as this YTD 2022 chart shows:

As you can see, CION has undertaken a round trip price-wise, returning almost to its lowest levels set earlier in the year.

There was no material development at the BDC that explains either the rise or the fall of the BDC.

At this point, CION trades at a (26%) discount to net book value and 9.4x 2022 projected Net Investment Income Per Share.

We estimate this year’s distributions will reach $1.3000, which suggests the current yield is 10.6%, well above the BDC average.

Up And Down

Also languishing this week were OFS Capital (OFS) – off (6.6%) and Trinity Capital (TRIN) – off (6.4%).

However, both BDCs – like CION – have recently been on an upward tear, but this week investors booked profits.

Over 2022 YTD OFS and TRIN remain 15.1% and 4.3% in the black. For reference – and using the S&P BDC index on a price only basis , the sector is up 4.9%.

No Exceptions

No BDC increased 3.0% or more in price or reached a new 52 week high, swimming against the tide.

The number of BDCs trading within 5% of their 52 week high – a useful indicator of animal spirits in the sector – dropped to 11, from 16 the week before and obviating three weeks of progress.

Likewise, the number of BDCs trading at or above net book value fell from 20 the week before to 19.

What’s Happening Here ?

One week of red ink by itself does not tell us much.

Moreover, it’s hard to be panicky when the sector remains 3.5% above the December 31, 2021 on a total return basis, according to S&P and 2.2% going by the price of BDCZ.

Nor was the BDC sector alone in terms of price drops this week: the S&P 500 was off (1.3%), and is now (5.8%) behind its year-end 2021 level.

Feelings

Nonetheless – and we’re going to be very unscientific here – we can’t help FEELING (always a tenuous way to invest) that sentiment in the markets is shifting – and not for the better.

Contraction Ahead ?

Every day, there seems to be another major investment bank predicting an imminent recession (2023 is the favorite time, but some will wait till 2024).

Bank America, Deutsche Bank and Goldman Sachs have all made this dire call.

(Goldman’s assessment has an especially faux quantitative sheen: placing the likelihood at 38%).

Then there’s the inverted yield curve for all to see, and to be mentioned again and again on the financial channels as a certain predictor of a coming slump.

Then there’s this:

A Bloomberg survey of financial professionals and investors indicates that the view [of a coming recession] is becoming more widespread. Only 15 percent predict a recession this year, but 48 percent predict one next year. They are concerned mostly about the inversion in the yield curve for two-year versus ten-year Treasury bonds, which means the two-year bond has a higher yield than the ten-year bond. A yield-curve inversion has come before every recent recession (although the exact causal connection between the two isn’t totally clear).

National Review – Dominic Pino – April 6, 2022

Are these predictions correct ? Who knows ! Undoubtedly, though, these drumbeats of dread must be affecting investor sentiment.

Reasonably Enough

BDC investors fear above all else economic recessions, which bring with them credit losses that will never be corrected; lower transaction activity and much uncertainty – the nemesis of all investing.

Greed or Fear

Although – as we’ve been noting for months – fundamentals are very strong in the BDC sector and earnings likely to get better (thank-you higher rates), we wonder if the fear of recession a year or more away will trump the likely higher EPS and dividends coming down the pike in the second half of the year and in 2023.

Markets are always running ahead, but just how far ? Does a dark pronouncement from the dismal scientists at an investment bank override a BDC payout that may possibly rise 15%-20% or more ?

Down. Then Up

Complicating the matter – with about three weeks to go to BDC IQ 2022 earnings season – is that the latest BDC results are unlikely to be stellar.

As we explained last week, the first quarter is typically slow and has been made worse by the war in Ukraine.

LCD reports that leveraged loan activity is (39%) off the level of IQ 2021.

Valuations of both debt and equity investments – given the lower level of the major indices and a less red hot deal environment – may well drop from the IVQ 2021 levels; impairing BDC asset values modestly and depressing NAV Per Share.

Less likely – but plausible – some BDCs may have to contend with a smattering of borrowers unable to pass on to their customers the higher costs that inflation has wrought.

We don’t expect to see any material uptick in non accruals but there may be more assets regarded as underperforming – rated 3 or 4 on our 5 point scale.

Later

Furthermore, the benefit of higher floating rates won’t yet be felt in the IQ 2022 results as most borrowers will still be protected by the “floors” negotiated with their lenders, but many BDCs may see an uptick in their own interest expense where secured facilities – typically floating rate based – are concerned.

By the second half of the year if all goes as the Fed has announced – or even before if we see 0.50% rate increases at every meeting – BDCs will be benefiting from the higher rates.

Besides higher investment income, BDCs that participated in the Great Refinancing of last year – when a slew of low yield, fixed rate medium term note financings were arranged – will barely see an uptick in borrowing costs.

(Every BDC is different in this regard and individual analysis is suggested for readers own favorite players).

In almost every case – as the BDCs themselves have shown in their quarterly filings where the impact of higher rates is quantified on a pro-forma basis – higher EPS will be the outcome of the Fed’s rates raising policy.

However, will investors decide discretion is the better part of valor and hold back even in the face of higher earnings and distributions ?

Grist For Our Mill

We don’t know, but expect the answer to show up in BDC prices – and be discussed in this column – in the weeks and months ahead.

Given the long time frames involved and the myriad uncertainties, it’s unlikely market participants will act in unison so any drop or any surge in prices is unlikely to be unanimous.

After all, despite all the nay-sayers (many of whom were praising the Fed to high heavens two years ago for “saving” the U.S. economy but now believe them to be incompetent), the U.S. economy remains in growth mode; unemployment is at a record low; consumers still have jingle in their pocket and rates – even when raised – will be at very low absolute levels.

At the moment, BDC investors – judging by the still very high level of prices – are relatively united in their optimism – this week’s results notwithstanding.

Prices Tell All

However, should there be a divergence of opinion about the future, we’re likely to see much more price volatility and an opportunity for BDC bulls to improve their returns if they are proven right by what does or does not happen in 2023-2024.

Bears might be best advised – given that BDCZ is trading only (0.5%) beneath its 52 week high and is up 2.0% YTD and 6.9% over the last year – to get going.

Most investors, though, are likely to be in the undecided camp and will be waiting around for a clearer picture.

The BDC Reporter will be here to provide the play-by-play.