BDC COMMON STOCKS

Week 22

Meh

This was an unexceptional week for the BDC sector after much recent high drama.

BDCZ – the UBS Exchange Traded Note which owns most BDC stocks and which we use as a price change measuring stick – was off (1.02%) in this week 22 of the year.

However, that’s only a fourth of the declines registered in weeks 19 and 20, and a world removed from the 6.2% gain registered last week.

No BDC reached a new 52 week high – or low.

In fact, only 3 BDCs increased 3% or more in price this week, versus 36 last week.

(There were also 3 BDCs that dropped -3% or more over the 4 days).

Overall, 29 BDCs decreased in price and 14 increased.

Gone

The most notable item of the week is that the BDC sector – and the Reporter – said good-bye to Newtek Business Services (NEWT).

NEWT’s Board and management believe they can live long and prosper as a bank holding company, rather than the BDC format with its many limitations intended to protect investors.

Shareholders approved the switch – as expected – this week, with 89% voting in favor.

Expunged

We’ve removed NEWT from our coverage universe, which includes the BDC NAV Change Table. (NEWT was not listed in the BDC Credit Table due to the nature of its business).

However, we will continue to list the former BDC’s two public Baby Bonds – NEWTL and NEWTZ – in the BDC Fixed Income Table until repaid, which is expected to be shortly.

A Little Smaller – In One Way

The BDC coverage universe – which peaked at 46 players – is now down to 43. We don’t know who might be added to our list in the future, but we have a suspicion there will be more deletions.

However, that will not slow the growth of the public BDC sector – most of which we track, except for players focused more on non-income producing investments – typically in early stage venture capital.

Extracted from the BDC Credit Table is the growth of the industry – quarter by quarter – since IQ 2020.

Zooming

In just two years, while the number of participants in the sector has fluctuated between 43 and 46, the aggregate portfolio AUM at fair market value has increased 47%.

Of course, some of that growth reflects mark-ups to existing assets but most consists of new loans and equity investments made by existing players.

Individual Results May Vary

We’ve added a column in the BDC Credit Table which shows the percentage change in each BDCs AUM since IQ 2020.

33 posted higher numbers and 10 smaller portfolios.

Peering Out

We’ll be interested to see if the sector as a whole can continue to eke out any asset growth in the next two years in the face of a prospective recession and projected lower leveraged loan activity.

On paper, with several BDCs still some way from reaching their optimal leverage levels net growth should be possible even if not one dollar of new equity capital is raised, but there are other factors that could restrain expansion: lower asset values; credit losses and a drop in leverage levels either to be “conservative” or in the absence of investment opportunities.

We may also see an increase in stock buybacks as almost every BDC has a repurchase program in place and the economics of buying in shares is very attractive right now.

Nonetheless, we’re optimistic that two years from now the BDC sector’s overall AUM will still be higher than the level as of March 31, 2022.

A 47% increase in the next two years, though, is unlikely…

We’re Back

Returning to the here and now, it’s hard to determine where the sector stands, and where it’s headed.

The obvious guess – and the one we believe is most likely – is that the BDC sector remains in a downward trend.

The huge surge recorded in the prior week when BDCZ jumped 6.2% – dragging virtually every player upward from the basement – was just a so-called “bear market rally”, or a “dead cat bounce”.

(Why does Wall Street favor so many animal idioms ?).

This week’s BDCZ price drop – and the fact that two thirds of BDC stocks resumed their price slides – would seem to confirm that outlook.

However, our one certainty when dealing with the markets is that one can never be sure.

Rational Adjustment

A minority view would be that the BDC sector has already taken into account the risks of a recession; continued supply chain issues; higher inflation, wage pressures, etc, etc. – all of which have been on the table for months now – and only taken a step or two back.

YTD, BDCZ is off (7.8%). Nothing to cheer about, but not even a “correction”.

Furthermore, the BDC S&P Index on a “total return” basis is off this year by only (4.9%).

There are plenty of investors out there in the broader markets who’d be delighted by such a modest drop given all the bad news that’s been coming this way.

Even now, 14 BDCs – a third of the universe – are trading at or above net book value.

22 of 43 stocks are trading in the black or with a price loss of less than (8%) over the last 12 months – i.e. with a gain on a total return basis.

No Problem

Moreover, we’ve noted a recent shift in market sentiment – which admittedly may not last – about the prospects of a U.S. or global recession.

Contrary to what Elon Musk was worrying about this week, the argument is that inflation will be beaten down sooner rather than later, and without the need for extreme measures by the Fed (i.e. a couple more rate hikes and no more) and the super strong economy will allow for that “soft landing” which everyone and their sibling was scoffing at very recently.

Round The Corner

Moreover, the rate hikes that have already occurred – and those coming in June and July (which together should add 1.0% to the reference rate) – should ensure a universal increase in BDC investment income and earnings.

Some of that will show up in the IIQ 2022 results and the rest in the IIIQ results – just round the corner.

If market fears are receding – or even stabilizing – will BDC investors walk away from the free lunch of higher BDC earnings and (presumably) dividends just a stone’s throw away ?

Maybe the drop in BDCZ year-to-date has just been the right response and the worst has passed ?

Investors sitting on the sidelines waiting to scoop up BDC stocks at much lower prices once a recession takes hold may miss a rally that could – thanks to those higher BDC earnings and dissipating fear about the economy – take prices up 20%-30% higher.

(We’ve added a 15% premium to the former BDCZ 52 week high of $20.69 to get to these numbers).

Looking Up And Down

On the other hand – and as noted last week – if a recession does great damage to BDC earnings and balance sheets, BDCZ and all the constituent players have a long, long way to drop in price if past performance is any indicator.

Not so very long ago, market leader Ares Capital (ARCC) was trading as high as $19.24 just before news began to come out of China of a new virus. That was February 9, 2020.

Six weeks later – as the pandemic took hold and investors panicked about an outsized recession – ARCC traded at $7.90 – a roughly (60%) price drop.

Yes, the Fed came along and rescued ARCC and everybody else with the greatest transfusion of capital in the history of mankind, and the BDC’s price quickly recovered.

The episode, though, is instructive in demonstrating how drastically prices can drop.

We can also agree that if a nasty recession results the Fed will not be coming to the rescue with anything like the speed or with the resources deployed in 2020.

Everything Is Possible

All of this to point out that BDC sector prices continue to be subject to a very uncertain environment which could cause – even several months into this “wall of worry” – extreme price volatility.

So far in 2022, investors have already encountered extreme turbulence but even more could be on the horizon or – less likely – we could be in for a quiet ride higher to new heights.

2022 – and most likely 2023 as well – could be most interesting years for everyone involved.