BDC COMMON STOCKS

Week 40

Catastrophic

Another terrible week for stock prices across the board – which will be a surprise to no one.

All the major indices continued in their relentless downward direction.

BDCZ – the U.B.S. exchange traded note which owns most BDC stocks and which we use to measure the sector’s direction – fell for a third week in a row, off (5.7%).

For those 3 weeks, BDCZ was down (15.6%).

Outstripping

We’ll get into the details shortly, but we’d like to note how BDCZ has fallen in price by a greater percentage than the S&P 500 in the past two weeks.

BDCZ is off (12.8%) over the past fortnight and the S&P 500 “only ” (7.6%).

For a time there BDCZ was materially outperforming the much larger index. As of now, though, and as this chart shows, the S&P 500 and BDCZ are in complete sync – down by almost the same percentage YTD.

BDCZ is now down (22.6%) and the S&P 500 (24.8%) on a price basis.

We believe that the narrowing of the differential in BDCZ and the S&P 500’s stock price reflects the near panic that has been in prevalent in the markets, with investors selling indiscriminately.

Mirror

That’s also reflected in what has happened to individual BDC prices.

Regardless of the size of your favorite BDC, or its strategy, prior performance or earnings outlook, its stock price was down. 42 of the 43 stocks we tracked were down in price.

At the moment, 41 BDCs closed the week within 10% of their 52 week lows, including 35 within 5%.

Record Busting

Speaking of 52 week lows, by our count (and we may have under-counted) 34 BDCs set new records in this metric this week.

Just 4 BDCs continue to trade above net book value per share, a fifth of the number just a few weeks ago.

Overall – and this is a new statistic calculated from data in the BDC NAV Change Table – the BDC sector is trading at 76% of book value.

There are a number of names – including some large BDCs who have performed very well in recent quarters – trading close to half their net book value.

High Yield

We also calculate that the average yield – calculated as estimated 2022 distributions to stock price – of the sector (and not counting the two non-dividend paying BDCs) is 12.5%.

That’s a yield we don’t remember seeing – except for the briefest of periods in March 2020 – for a very long time.

Broader Picture

Again – if we ignore the strange, uncertain period between February 20 and March 30, 2022 when we both entered and began to exit the fear of a global pandemic triggering a worldwide recession – BDCZ is trading (25%) or more below the top price levels achieved by the ETF between October 2015 and February 2020. See the BDCZ lifetime chart below:

For those who like those sort of statistics, BDCZ is now trading approximately (35%) below the highest level of BDCZ reached in April 2017.

Not The Same

By the way, in the spring of 2017 the Fed Funds rate was in a range of 0.75%-1.00%. At the moment, the range has moved up to 3.0-3.25%, and could yet head higher.

On paper, that should boost BDC investment income by about 25%, much of which should drop to the bottom line and increase dividend payouts.

Upside Down

Or, in other words, if everything was equal, BDC stocks should be trading at a premium to the 2017 BDCZ high, rather than (35%) below.

We could make a viable argument that BDCZ should trade closer to $30.00 rather than $15.52, but who would listen ?

Deja Occurred

At the moment, investors are focused on every conceivable downside scenarios.

These mostly revolve around some sort of 2008-2009 freeze-up of the several trillion dollar sized leveraged finance industry, possibly as part of an even broader crisis of confidence in the global capital markets.

With nobody buying or selling, loan values would drop.

That would have the knock on effect of causing BDC net equity values drop thanks to applying “fair market values” to investment assets. [ In fact, that methodology is unfair – both to the BDCs and their shareholders, equating the long term value of loan and equity investments with a much shorter period of illiquidity].

Then BDCs would be forced – under the logic of this scenario – to sell off assets at huge discounts to right their balance sheet, or sell stock at a huge discount to book.

Either way, shareholder values would get greatly – and permanently – diminished even when the machinery of finance would sputter back to life.

This would validate the current drop in BDC prices and would bear more than a passing resemblance to what happened in the Great Recession and threatened to occur during the 2011 European financial crisis.

Credit Tsunami

Another scenario is that even if the leveraged finance industry does not freeze-up, an avalanche of BDC financed loans will become non performing (i.e. go on non accrual) and that will be followed by a huge increase in realized losses.

Like the prior scenario, BDC shareholders end up – at the end of the day with much diminished capital.

This scenario, which might take longer to play out, would also validate the recent drop in prices and the prescient “wisdom” of the market.

Again, this scenario borrows from what occurred in the Great Recession, and in its aftermath.

Citing Precedents

On a much smaller scale, there was an upsurge in BDC bad debts following the oil price crash of 2013, as many energy related loans that should probably never had been made, cratered from 2014.

More recently – and on an even smaller scale – there have been periods of above average credit losses lasting all the way up to the pandemic.

A few BDCs suffered serious losses from poor credit underwriting, while others were unaffected.

Best Of Times

Ironically, since 2020 when the Fed and the U.S. Government flooded the economy with capital (PPP “loans”; airline subsidies; ; new SBA programs etc.) credit losses have dropped to record low levels all the way through the IIQ 2022.

Even with the IIIQ just closed, there are few indications that credit stresses are materially increasing. The BDC Reporter – and in our sister publication the BDC Credit Reporter – we’ve been looking for the early signs that precede a jump in non accruals and credit losses.

Systematically

We’ve been looking around in the public record announcements that pertain to the 7,000+ BDC portfolio companies and in the filings of the public and private BDCs.

In addition, we’ve been paying attention to what is being said in the large syndicated market for floating rate loans; the CLO market and high yield bonds.

Going by what the markets are telling us – and what the rating agencies are predicting – credit losses should rise, but are not expected to reach catastrophic proportions.

In fact, credit losses may just move up from being below the long term average to reverting back to the mean – at worst.

Our View

For our part, we continue to project that higher earnings from rising interest rates will comfortably offset any income lost to bad debts or failed equity investments.

We expect – on average – net book values to fall no more than (5%-10%) by the time this is all over, even if – for a time – the decrease is higher.

Patience Required

Unfortunately, BDC investors may have to wait – barring any new twists or turns – till 2024 to have a good idea whether these projections make sense.

In the interim, we expect many ups and downs where BDC common stock prices are concerned.