BDC COMMON STOCKS

Week 24

Pretty Obvious

You don’t need the BDC Reporter to know that BDC common stocks had a no-good, terrible week.

Anyone paying the least attention will have seen the rivers of red across the BDC sector, as well as the major indices.

Read And Weep

However, we can provide some specifics and context.

BDCZ – the UBS Exchange Traded Note which owns most BDC stocks and which we use as a proxy for price changes – was down (7.52%).

As of Thursday’s close, the drop was even greater but Friday brought a brief reprieve.

Worst Since…

BDCZ has not dropped in a week by that great a percentage since the March-April 2020 pandemic.

(Admittedly, back then – in a reminder that things can still get worse – the weekly drops were occasionally 3x as high as what we’ve just experienced).

Almost Universal

Of the 43 public BDCs we track, 42 dropped in price this week.

(Here we’d like to give a shout out to Great Elm Capital – GECC – which managed a slight gain).

Some of the price drops were huge: as much as (18%) – Cion Investment (CION).

In fact, 16 BDCs fell by double digit percentages.

Not A Pretty Sight

This may not have been a full fledged rout as we experienced two years ago, but it was a disorderly retreat where nobody – except GECC – was spared.

Even if you announced a big increase in your distribution and promised juicy special payouts for the rest of 2022 – as did Trinity Capital (TRIN) – your stock price still dropped.

TRIN was down (7.4%), pretty close to the sector average.

Nothing Left

With this great wash-out, there are now no BDCs trading within 10% of their 52 week highs.

Last week, at least, there were 4 and at the beginning of April 33 !

Into The Deep

In fact, 39 BDCs reached new 52 week lows during the week – mostly on Thursday as the sell-off became systematic and indiscriminate.

(We know this because we update our database manually, which took ages this week with all the new 52 week lows to input).

Sector Stands

BDCZ is now (16.6%) down in price on the year and (19.1%) lower than its high set just a few weeks ago on April 21 intra-day.

As opposed to the NASDAQ and S&P (which was down 5.8% this week – worst since the pandemic), the BDC sector is not yet in “bear” territory, but is close enough.

Relatively Speaking

Could prices get worse ? Of course, judging by the price performance during the pandemic when investors – incorrectly as it turned out – last anticipated a recession.

BDCZ fell as low as $8.87 intra-day and $9.12 at the close of day back then.

From Friday’s closing price that still leaves a prospective (47%) further drop in price for BDCZ to match 2020’s lowest ebb.

We also note that during the darkest days of the pandemic freak-out, no BDC traded above net book value per share. Currently, there are still 8 in that category popular with investors.

The BDC Reporter Speaks

We like to think that the BDC reporter not only tells our readers what’s been happening, but also offers up our own view, which everyone is free to do with as they will.

We’ve been giving a great deal of thought – and sharpening a number of pencils recently – regarding what might happen to the BDC sector in a prospective recession. After all, recession is all anybody is talking about in the financial community and that’s unlikely to change.

Coincidentally. on Thursday, I was asked to speak by Advantage Data (now Solve Advisors) on one of their periodic webinars about just this subject. Or, more specifically, I was asked whether we should expect the next recession – probably slated for 2023 according to most every economist – to cause as much damage to the BDC sector as the last one in 2007-2009.

As BDC prices were crashing, the BDC Reporter was opining that the much feared coming recession- in our humble, if controversial opinion – will result in far less damage to BDC earnings, dividends and balance sheets than occurred in the Great Recession.

That Was Then

Back then, 80% of the players in the market were forced by market conditions to reduce or suspend their distributions.

Furthermore, many BDCs were permanently damaged by the experience and never fully recovered from the downturn, with most ending up eventually sold off for much less than they were worth before the crisis or limping along ever since.

In the darkest days of 2009, the very continued existence of a BDC sector seemed in doubt and investors almost across the board despaired as prices dropped as much as 95% off their prior highs.

This Is Now

Our argument – as regular readers might suspect – was that the BDC sector is far less risky as to the types of investments being made recently than back in the run up to the Great Recession; balance sheets are stronger thanks to the Great Refinancing of 2021 as BDCs swapped out floating rate, secured bank borrowings loaded with covenants for fixed rate unsecured debt virtually covenant free and credit quality – in most instances – is as good as one has the right to expect in advance of a coming storm. (Thank the Fed for flushing huge amounts of capital into the system in 2020-2021).

Then there are the intangibles of BDC managers being much more experienced than they were back then in navigating difficult conditions and the several quarters of advance notice being received about the slowdown ahead. That gives BDC managers plenty of time to batten down the proverbial hatches, while back in 2007-2009 the deterioration came on very fast.

Gone Too Far

All of this to say is that we believe that with is latest drop in prices (and maybe even earlier), the BDC sector has moved into “oversold” status versus where we expect fundamentals will bottom out if and when a recession hits in 2023-2024.

Like many of our readers and all the analysts, we’ve been running pro-forma worst case scenarios for individual BDCs and cannot match the current prices with our darkest expectations once the recession hits and plays out.

Admittedly, there are an endless number of assumptions and suppositions involved about unknowable future outcomes, but that’s the nature of investing, especially when there’s a drastic change in the weather.

Too Low

In a nutshell – and with only a few exceptions – we don’t believe that once the recession has come and gone, and the economy recovered that the public BDCs we track will be trading as low as the prices recorded on June 17, 2022.

Long Time Frame

Unfortunately, though, we may have to wait till 2024 or 2025 to determine if we’re right as these things do take time to play out. We’ve not even had in the BDC results through IQ 2022 much of any of the conditions that will become prevalent as economic conditions worsen: deteriorating EBITDA levels at borrowers; a big increase in interest rates; a sharp slowdown in financing activity and an equally sharp reduction in pre-payments; an upsurge in defaults followed by a stream of restructurings, bankruptcies and liquidations. When that’s over, there’s still the early recovery to get through, which may or may not involve lower interest rates; a slow pick-up in new transactions; better borrower earnings and a continuing process of determining which companies will survive and in which form.

Quick Draw

As always where the BDC sector are concerned, investors appear not to be willing to wait around to see what might happen.

The indiscriminate breadth of the pullback in a very brief period suggests this is standard “shoot first and ask questions later” and occurs – both in the broader markets and where the BDC sector is concerned – every time a recession threatens.

In fact, we’re impressed that the BDC sector – and BDC investors – held off so long from joining the broader markets rush to the exits.

Ever More ?

While we believe that the BDC price drop versus the pro-forma post recession fundamentals is overdone, we’re less certain that the red ink is done.

In the past – unless some unexpected salutary “good news” pops up (like what the Fed engineered in the pandemic) – these sort of price drops tend to feed on themselves. At the moment – short of a sudden and drastic drop in the inflation data – we can’t imagine what that might be.

Even investors who agree that fundamentals will hold up in 2023-2024 will be looking for a lower re-entry point as everything points to worse days ahead.

Unknown Future

Then there’s always the possibility of “known unknowns” that could occur in the months ahead as the recessionary path changes. Back in the Great Recession we had shocks like the Bear Stearns and Lehman bankruptcies.

Understandably, most investors would rather wait out those kind of uncertainties, especially as we are still so far from the eye of the Fed-engineered economic storm.

From a BDC perspective, we’re unlikely to see the bulk of any credit problems crystallize till mid-2023. Unfortunately that might mean that the degree of certainty which investors crave – and which is the necessary pre-requisite of sustainably higher prices – might still be a year, or more, away.

Another Variable

Also unclear is where rates might end up in all this. If we get a recession, does the Fed suddenly reverse course where rates are concerned and start cutting after multiple raises ?

The answer – given the wide range of the rates – will also have a great influence on BDC profitability, or otherwise.

No Rest For The Already Weary

That’s yet another reason to believe no consensus on the way forward for the BDC sector looks to be in the cards for quite some time.

All of the above – regardless of what we believe about fundamental values – suggests price volatility will be with us for some time to come.