BDC COMMON STOCKS

Week 30

Two Roads Diverged

Greed versus Fear.

Back in April, BDC investors – whose optimism had pushed the sector to new price heights – were overcome by fear of a coming recession.

Notwithstanding the prospect of higher earnings in the offing thanks to higher interest rates and a still active financing environment, BDC investors largely abandoned ship.

Between April 20 and June 16, the S&P BDC Index – on a price return basis – fell (21.1%).

Everyone Everywhere

A similar phenomenon was happening in the broader markets, although on a slightly different time scale.

For example, the S&P 500 began falling after March 29, but also reached its 2022 nadir on June 16, losing (21.8%), even though there is barely any similarity in the composition of the BDC index and the S&P 500.

Big Mo Is Back

In any case, since June 16 – 6 full weeks – investors of every stripe – including those invested in the BDC sector – have been in rally back mode.

At the close on Friday July 29, 2022 – conveniently at month’s end – the S&P BDC index had risen 12.9% (and the S&P 500 12.6%).

FOMO

Now investors appear to be anxious less about being hammered by a global recession – still very much on the horizon according to the latest data – than by missing out on recovering securities prices.

(Coincidentally or otherwise, bond prices – including the public BDC unsecured debt – also turned the corner of late.

The 18 Baby Bonds the BDC Reporter tracks increased 0.82% in price this week, versus a 0.01% gain the week before and a (0.88%) drop just a fortnight ago.

15 of the 18 BDC “Baby Bonds” were up in price on Friday over the prior week).

Makes Sense

In a way, going by what we were hearing from some BDCs in the first week of earnings season, this rally made sense.

After all, everywhere you turn in the BDC universe, the outlook is for higher EPS this quarter and through the rest of the year, as well as higher dividend distributions.

Ever More

Ares Capital (ARCC) led the way when reporting its IIQ 2022 results by increasing its “regular” distribution from $0.42 to $0.43.

Just as importantly, the market leading BDC – notoriously slow to boost its pay-out until legally necessary – suggested more hikes might be on the way, as we noted in the BDC Daily News Feed where we track these developments in near real-time:

The icing on the cake was an increase in the regular distribution to $0.43. The cherry on the icing were comments made by management that EPS would have been even higher in the second quarter if all interest rate increases had been reflected over the whole period. That’s code for a likely further boost in EPS in the next quarter. The analysts were previously calling for $0.46, but we could see the number reach $0.50 or more, and further increases might be coming in the final period of 2022

BDC Reporter – BDC Daily News Feed – Ares Capital – July 26, 2022

Ditto

Hercules Capital (HTGC) – which also reported IIQ 2022 results – also hiked its regular distribution to $0.35.

If that wasn’t enough, both ARCC and HTGC are currently paying out quarterly special distributions that will last all year.

Even when those “specials” are completed, the two BDCs still have small mountains of undistributed taxable income sitting on their balance sheets.

Newer BDC Runway Growth Capital (RWAY) also announced an increase in its quarterly distribution, which jumped 10% after increasing by a similar percentage in the prior quarter. And the quarter before that.

Like The Nose On Your Face

Even without the benefit of a formal announcement, BDC investors could do the math after the Fed – not unexpectedly – raised short term rates by 0.75% and indicated a similar increase is coming in August.

The base rates are now well over any BDC’s “floor” and every such increase is benefiting BDC investment income across the board.

With essentially every BDC enjoying floating rate loan assets and having a large proportion of fixed rate debt liabilities, the writing is on the wall for higher BDC EPS for several quarters to come.

The question is less who might benefit from higher interest rates- because every public BDC is a candidate – but by how much.

Gone With The Wind

Absent for the moment are investor concerns about BDC creditworthiness, even though all 5 players that have reported to date saw their NAV Per Share drop from the prior quarter.

As the BDC NAV Change Table shows, the average, non-weighted, decrease was (6.4%).

Rooting Around

Our own review of the portfolios of the BDCs that reported results this week and previously (i.e. Saratoga Investment) suggested there was some weakening in credit metrics overall, and a few de novo non accruals.

We’ll take up the subject at greater length in a full length article next week, but have to admit that whatever credit deterioration has happened is still modest at this time, and below the average historical levels.

Either Way

BDC investors seem to betting either that credit conditions won’t get seriously worse, or that any losses that might be headed this way will be handily offset by those ever higher earnings anticipated.

By the way, the BDC Reporter is in the latter camp.

Depends

The result will be – as we’ve said previously – an interesting situation where earnings jump as net book value fall – possibly permanently.

If you calculate BDC return on equity by dividing earnings or distributions by net book value, ROE will be very high – possibly the highest ever.

However, if you calculate ROE by taking into account both earnings/distributions AND changes in net book value, the return will be far lower and – potentially – negative.

Happy Days

For the moment, though, BDC investors have rose colored spectacles on.

This week, 35 BDCs increased in price – including 10 by 3.0% or more.

For the first time in a while, multiple BDCs (7) showed price gains on a YTD basis.

The number of BDCs trading above net book value per share, which had dropped to just 8 players a few weeks ago – has risen back to 14.

Using the 50 day moving price average – a favorite tool of traders and market timers – 29 BDCs were in the black and in the past 4 weeks, 39 BDCs have seen an increase in their prices.

Not There Yet

Still, the damage wrought to the BDC sector between April 20 and June 19 was considerable and – as we discussed last week – much more rallying will have to happen to fully turn the year around.

For example, the S&P BDC index will have to increase by 12% to match its 2022 high and BDCZ 14%.

The number of BDCs trading above net book value will need to jump by 42% – from 14 to 20.

Aim Low

However, if an investor’s ambition is just to break-even, that’s a prospect that is in sight: the S&P BDC index calculated on a total return basis – which includes distributions paid out as well as price changes – is only (3.5%) down in 2022.

(In fact, over a 12 month period, BDC buy and hold investors – as measured by this all-inclusive index – are still up 3.2%. That’s nothing to write home about in absolute terms, but given all the recent stock market drama, worth noting).

Complicated Outlook

Looking forward – and with the likelihood that more BDCs will be announcing stable or increasing distributions and hinting at even better results in the second half of the year – this rally may continue.

Nonetheless, there is no denying that i) global economic conditions are getting worse; ii) inflation remains higher than tenable and iii) investor sentiment is subject to drastic changes in mood.

(After all, even in late April when BDC investors ran for the exits, everyone knew higher rates and plumper distributions would be coming).

Nothing Stays The Same

More debatable – but not unlikely – is that BDC credit losses might begin to pick up over the next twelve months and – in a related development – the Fed might decrease the very same interest rates that they’ve been so drastically increasing.

All the ingredients are there for the BDC sector to go the way of the souffle: rising in the oven, only to collapse when taken out.