BDC COMMON STOCKS

Week 27

Climbing Back

The BDC sector is fighting its way back from its lowest lows set on June 16, 2022.

For a third week in a row, BDCZ – the UBS sponsored exchange traded note which owns most BDC stocks and which we use to measure price action for the sector – was up.

This week’s percentage increase was 1.5%, following gains of 2.8% and 3.1% in the prior two weeks.

On a total return basis – using the S&P BDC Index – this week’s gain was 1.66%.

Mostly Positive

Like in the prior two weeks, roughly three-quarters of the individual BDC stocks we track were up in price or unchanged (33), and a quarter were in the red (10).

Generally speaking, price volatility was less extreme than in the prior fortnight, with 7 BDCs up 3.0% or more and 2 down (3.0%) plus.

The most notable change in price was recorded by Logan Ridge Finance (LRFC), following the tiny ($207mn portfolio) BDC’s refinancing/recapitalization of one of its largest portfolio companies.

The BDC Reporter briefly analyzed this latest development on July 6 in our new feature – the BDC Daily News Feed.

LRFC’s management calls the transaction “transformative”, and its stock price increased 13.6%.

We’re not convinced as yet , and will wait to get a fuller picture when the BDC – which used to be Capitala Finance – reports second quarter results.

Bounce

There’s no arguing, though, that the news stymied LRFC’s stock price drop, as the fast money crowd jumped in and the volume of shares traded jumped up, as this stock chart illustrates:

Looking Up

Nonetheless – and LRFC’s example may stand as a useful example for the BDC sector more generally – there’s a long way to go yet.

This BDC is still trading (39%) below its 52 week high and at just 45% of net book value per share.

Ditto

In a similar vein, BDCZ remains (13%) below its highest point of 2022, despite 3 weeks of rallying.

Tellingly, of the 43 individual BDCs we track, 42 remain in the red year-to-date.

Still Damaged

Even if we narrow the time frame – using very helpful Seeking Alpha data – only 5 BDC stocks are trading higher as of Friday July 8, 2022 than they were 4 weeks ago.

Using a 200 day moving average price there are only 2 BDCs up in price.

Even after 3 weeks of price increases, no BDC trades within 5% of its 52 week high and only one between 5%-10%.

Roughly half the BDC universe remains close to their lows, with 5 within (5%) of their 52 week nadir and 18 between (5%-10%).

As in the prior two weeks, the number of BDCs trading at or above net book value per share remains 10, half the number we counted in early April.

Ways To Go

Basically, we’re arguing that the BDC sector has fallen and is still some ways from getting up.

Those periods of near panic take a toll.

For example, between June 7 and June 16, BDCZ dropped (12%) in price.

Sustainability

Moreover, one has to wonder how long the current rally can last.

Looking back over our records, we’ve not seen BDCZ increase in price 4 weeks in a row since June 2021.

Deciding Factor

Maybe the upcoming IIQ 2022 BDC earnings season will make a difference.

This week – as our Premium subscribers know from the three in-depth articles we’ve written on the subject – Saratoga Investment (SAR) kicked off the second quarter with its quarterly results, reported after the close on July 6.

Not Writing Home

If we go by the metrics – Adjusted EPS in line or slightly below analyst expectations; a (2.2%) drop in NAV Per Share; the addition of a new non accrual and a new underperforming portfolio company – SAR can be said to have posted relatively mediocre results.

This was quickly reflected in its stock price, which dropped as much as (6.5%) in the first hours of trading of July 7 after the quarter’s numbers were posted.

In a typical fashion, trading volume increased sharply as some investors bailed and this continued for a few hours.

Deep Breath Taken

Then the market had second thoughts – possibly influenced by a confident and detailed conference call showing by the BDC’s senior management in the morning of July 7.

SAR’s price partly recovered and ended the week (2.2%) off the price reached just before results were reported and (1.3%) for the week.

What Matters Most

All this suggests investors – at least at the moment – are paying attention to fundamentals and are not in the grip of either enthusiasm or dread about the bigger macro issues affecting the economy and the markets.

Booster Shot

Friday’s positive jobs report was probably good news for the BDC sector in the short run, almost ensuring we’ll get another 75 basis point increase in the reference rate to go with the one that occurred in June.

That’s a 1.50% fillip to floating rate loans in about 30 days, and just as most every BDC has reached its interest rate “floor” level with borrowers.

With – at least three quarters of the BDCs out there generating a yield on income producing assets under 10% (including many under 7.5%) – a 1.5% increase in rates is a game changer where investment income is concerned.

Admittedly, some of that benefit gets offset by higher interest expense on floating rate borrowings, but not much.

Rhetorical Question

What other industry in the midst of current conditions that are mostly squeezing margins and profits can boast such a sharp increase in net spreads ?

Soon But Not Yet

Unfortunately, if the proof of the pudding is in the eating, we won’t see much of the benefit of higher rates showing up in the IIQ 2022 BDC results.

Those income gains will be arriving in the second half of the year, and will be a gift that keeps on giving as rates increase from Fed meeting to Fed meeting.

Previewing

However, we expect the subject will be high on the agenda both for BDCs reporting their latest results and for investors.

This week, we got a taste of how significant those interest-rate driven earnings gains could be in SAR’s 10-Q.

Let’s set the stage, and remind readers that the BDC’s adjusted net investment income per share was $0.53 in the quarter ended May, or $2.12 per share annuaslized.

In its 10-Q, this is the annual benefit SAR calculated might come from interest rate hikes of anywhere from 25 basis points to 400:

To be “conservative”, we typically look at a 200 basis point increase to evaluate the impact on BDCs.

Between the 75 basis points already implemented in June and the likely 75 basis points in July, we’re almost there already.

Fed watchers are expecting another 1.0% in the rest of the year, bringing the incremental change since the end of May to 250 basis points by December 31 – less than 6 months away.

The math suggests NIIPS could be boosted by $1.50 on an annual basis by then.

Numbers Speak For Themselves

Clearly, that’s a huge POTENTIAL increase in earnings without SAR – or any of the BDCs in a similar boat – having to do much of anything except watch the additional monies roll in.

Cleft Stick

As this opportunity comes into greater focus, BDC investors are going to be caught having to decide whether to be predominantly worried about the impact of the seemingly unavoidable recession or the increased earnings outlook in BDC stocks.

Which way will the market jump ?

It’s a puzzlement.

Crystal Ball Gazing

Of course, we don’t know, but our view – and we’re going way out on a limb by saying so – is that the BDC sector will come through the coming recession with higher earnings than when going in, even after losing some income to non performing loans and watching net asset values drop.

The irony might be that BDC returns on equity (calculated as earnings or dividends divided by net book value per share) could increase in the rest of 2022 and into 2023 despite an economic contraction.

Root Cause

This is largely due to the unusual nature of the coming recession, essentially manufactured by the Fed by constantly raising short term rates.

In prior economic slowdowns, the Fed has rushed to lower rates when economic conditions worsen.

That’s what happened in the Covid recession of 2020, and those lower interest rates wreaked havoc on many BDC’s EPS and distributions.

This time, the Fed will be pushing up interest rates – as they’re already doing – even in the face of weaker GDP and other metrics.

Timing Is Everything

The key uncertainty is whether the Fed can take its foot off the interest rate pedal at just the right time – by lowering rates – to minimize damage to the economy and to all those highly leveraged borrowers the BDCs have on their books.

Slip Up

Or will the damage spiral out of control, saddling all lenders – including the BDC sector – with a plethora of bad loans; lost capital and forgone interest income ?

Adding insult to injury, the Fed would then be lowering rates – expected in 2023-2024 – just as the BDCs were contending with all those new bad loans.

Sanguine

We believe the Fed can and will thread this needle – although we’ll have to wait at least a couple of years to be sure – which should benefit the BDC sector.

It’s doubtful that when all is said and done short term interest rates will drop back to a level below BDCs floors or that credit losses will reach the monumental levels of the Great Recession.

Instead – we’re guessing – that some sort of equilibrium will be achieved which will see loans priced higher than in 2021 – generating substantially higher income for BDCs.

At the same time, credit losses will also be going up, but not sufficiently to offset the benefit of higher rates.

(The wild card in all this is a financial crisis that might capsize the normal functioning of the markets and force BDCs and other lenders into forced sale of assets or other extreme measures to stay solvent. This is what happened in the Great Recession – but at no other time before or since in the history of the sector).

We’ve Only Just Begun

In any case, the next 6-8 quarters should be unusually instructive for anyone involved with the BDC sector.

There have been many significant twists and turns already and we’re only 6 months in to what will be a defining period for this corner of the financial market.