BDC COMMON STOCKS

Week 28

Counter Intuitive

In a week where the economic data for both the U.S. and the world economy darkened, stock prices went on an upward tear.

In the U.S., the labor market cooled; U.S. and European business activity shrunk for the first time in two years and Citigroup economists rated the chance of a global recession at 50% while the Bank of America argues that the U.S. will be in contraction mode later this year.

Admittedly, we could just as easily have shown you articles promising a “soft landing”; inflation dropping and no recession on the cards this year or next.

Nobody Knows

That’s the problem in a nutshell: there is no market consensus on even the biggest issues, let alone shorter term subjects like what the Fed is going to do about interest rate increases.

The result is continuing price volatility as sentiment swings one way and then another.

Hopeful

Of late, the mood has been favorable for stocks.

This month – and this week – the major indices moved up – despite a bleak Friday.

The S&P 500 was up 2.55% since July 15, 2022.

The BDC sector – as measured by the price performance of the UBS-sponsored exchange traded note that owns most of the public stocks with the ticker BDCZ – performed much the same way : up 2.08%.

The BDC S&P Index – calculating on a total return basis – jumped up 2.47%.

Sticking Together

By the way, in the last month BDCZ and the S&P 500 – whose price fortunes diverged somewhat earlier in the year – have become almost joined at the hip, as this chart s hows:

The inference we draw from that synchronization is that BDC investors are looking – like everyone else – at the big picture outlook.

Beneficiaries

Luckily for those BDC investors, the markets have been in that sanguine mood of late.

This is reflected also in the number of BDCs that increased in price this week or stayed unchanged: 40 out of 43.

That’s the largest number we’ve seen since a similar rebound in the week ended May 27 after prices had dropped to their then lowest level of the year on May 20.

Since May, we’ve seen BDCZ reach a further nadir on June 16 and then increase 7.4% through last Friday.

Better But Far From Best

For anyone with FOMO (Fear Of Missing Out), we can only point out that we’ll need much more in the way of rallies to get BDCs back to the state they were in for 2021 and in 2022 through April 20.

Only 1 BDC – according to our database – is trading between 5%-10% of its 52 week high, and none in the 0%-5% group.

This week the number of BDCs trading at a premium to net book value per share increased from 10 to 11, but still remains at half the level of the golden days of yore.

One. And Only.

Year to date, only 1 BDC can boast of having increased in price.

That’s Fidus Investment (FDUS) – which we discussed last week – which has managed to slough off an analyst downgrade and a higher risk credit profile to be the emblematic exception to the BDC rule in 2022.

Many well regarded BDCs – often with investment grade ratings; long track records of unchanged or increasing dividends and very little in the way of credit problems – have dropped by double digit percentages from their 52 week high prices.

Just to name a few, there’s Capital Southwest (CSWC) off (22%); Barings BDC (BBDC) off (13%) and newly public BDC behemoth Blackstone Secured Lending (BXSL), down a remarkable (31%).

In all, there are 25 BDCs down (10%) or more through the first 28 weeks of 2022.

Most of those should perform well – both in terms of fundamentals and stock price performance – under “normal” conditions.

Long And Winding

In our opinion, though, and notwithstanding the five week bounce back from the lowest lows of 2022, we remain many months away from any sort of clarity about the way forward so any sustained price recovery seems unlikely.

Uninstructive

Moreover, the coming BDC earnings season – as we’ve warned before – is unlikely to bring any definitive answers for investors.

None of the key elements that would be/will be present in a recession are yet at play in the quarter ended June 30.

No Freeze

In a “normal” downturn, investment activity freezes up for leveraged buy-outs; add-on acquisitions and recapitalizations.

By contrast, from everything we’ve divined so far – admittedly patchy and anecdotal – BDCs of all stripes have been feverishly adding new investments in recent months, outdoing the first quarter and – possibly – the level at the same time last year.

Going Up. Not Down.

In a “normal” downturn, the Federal Reserve tries to rescue the economy and minimize the impact by reducing interest rates. For BDCs that typically adds insult to injury as lower loan activity is joined by lower investment income.

Clearly, this time the Fed has been, and will be, raising rates for at least the beginning of any downturn.In the second quarter of 2022 a modest amount of those rate increases will show up in BDC results but most of the impact will be felt in the third and fourth quarters.

In Flux

Analysts and investors will be busy adjusting their financial models every month as the Fed raises x basis points, sometimes several times in a quarter.

We can say with a high degree of certainty that investment income and net investment income levels in the second half of the year will bear little resemblance to the coming IIQ 2022 numbers investors are looking forward to seeing.

No Asset Destruction

In a “normal” downturn, asset values swan dive, causing leveraged loans, as well as preferred and equity stakes to fall out of bed for a period. Unbelievable as it may sound to some recent investors in this space, values can drop by (10%), (20%) or even (30%) plus. We may get that later in the year or in 2023 if past is prologue.

However, in the IIQ 2022, based on those same patchy and anecdotal findings we’ve garnered – asset values are likely not to have moved much. There may be slightly lower numbers and NAV Per Share overall is likely to be down in the second quarter after many quarters in a row of positive results, but nothing spectacular as was the case in the darkest days of the Great Recession or – for a brief moment – at the beginning of the pandemic.

Open For Business

In a “normal” downturn, financiers of all kinds – BDCs included – find the debt and equity markets almost completely closed to them as investors adjust to new conditions. This time – and all the way through this week – investors continue to funnel new capital new funds to BDCs.

Regular readers will be aware of the new Baby Bonds issued by Trinity Capital (TRIN) and by Runway Growth Finance (RWAY). The latter BDC also raised equity capital in April by issuing new shares.

Unperturbed

In a “normal” downturn, many BDCs – either out of caution or necessity – take preventive measures to protect themselves. Not so very long ago, Saratoga Investment (SAR) unilaterally suspended its quarterly distribution in the early days of the recession. The currently much beloved FDUS was also alarmed back in 2020 and reduced its payout and warned of the possibility of losses that never came.

In the Great Recession, many BDCs sharply reduced or even suspended their distributions to preserve capital and to bring leverage within regulatory limits. Some BDCs only paid out distributions in the form of more stock to preserve cash. Many BDCs shrunk their portfolios both in 2008-2009 and in 2020 in order to be “safe”, often turning down new loan originations that they would previously have eagerly gobbled up.

As far as we can tell, nothing like that is happening in 2022 to date. Many BDCs – we believe – are unabashedly growing their portfolios, often taking advantage of pullbacks by other participants when the opportunity arises.

Price Running Ahead Of Performance

All of this to say that the financial and credit conditions that BDC investors have presumed will be forthcoming – and have caused BDCZ to drop (11%) from its April height – will not yet be reflected in the IIQ 2022 results.

In fact, if there was not the drumbeat of a future downturn – most of the fundamentals that will be on show in the weeks ahead as results are announced – would suggest a BDC sector growing in size; diversity and earnings power,; increasing its distributions and with nary a headwind from credit conditions.

A Long Time Coming ?

Even now, the analysts are largely projecting BDC earnings will increase in 2023 over 2022 levels, implying that the day of reckoning where BDC fundamentals match their lower price levels could be many more quarters away.

Which is not to say we won’t be fascinated by what we learn from July 26 on when Ares Capital (ARCC) and Oxford Square (OXSQ) lead off earnings season, but there will probably be much reading between the lines and looking for cracks in the data to evaluate what the rest of the year and 2023 might bring.

That sort of situation leads to investor uncertainty which, in turn, fuels price volatility.

We might be in this unsettled period for much longer than most BDC investors – many of whom are on the sidelines – would like.