BDC Common Stocks

Week 7

Divergent

Just a week after commenting on how BDC sector prices tended to follow the lead of the major indices, a divergence occurred.

The S&P 500 was down for a second week in a row -by(0.3%) – as concerns grew that the Fed would need to continue raising rates longer and higher than previously anticipated because of the strength of the economy and of inflation.

There’s an excellent article – amongst the dozens we read every week – in Forbes.

Brushed Off

The BDC sector, though, was not deterred with BDCZ – the UBS Exchange Traded Note which we use to measure price performance – jumping 1.6%.

The upward move was relatively broad, with 33 individual BDC stocks up and 10 down – almost the exact inverse of the week before.

Also in an inverse performance were the number of BDCs increasing or decreasing more than 3.0%. This week there were 8 of the former and 0 of the latter. The week before there were 8 in the red and just 1 in the black.

Flipped

Amusingly, one of last week’s leading downward movers – Hercules Capital or HTGC– shot up 14.0% this week, leading the sector in terms of the percentage price increase.

That seems to confirm the suspicion mentioned in our prior article that a great deal of investor positioning is going on in advance of earnings being released.

Wronged

In this case, investors were being way too pessimistic as HTGC reported all sorts of record results; increased its distribution, and even managed to increase its NAV Per Share.

Ditto

Sixth Street Specialty (TSLX) also reported strong results, increased its regular distribution, and also increased NAV Per Share but did not quite get HTGC’s rapturous welcome – “only” increasing 2.85%.

Notable

Also noteworthy – and very rare of late – a BDC reached a new 52-week high.

That was Stellus Capital (SCM), which reached $15.73 on Thursday, before falling back slightly by the week’s end.

The BDC’s stock price has been shooting up like a rocket of late, as this chart shows:

The BDC has not yet announced the date of its IVQ 2022 earnings release.

We’d guess the enthusiasm for this smaller BDC might be related to its 43% (!) increase in its distribution that was announced over a month ago.

Close By

SCM remains something of an outlier, as there are no other BDCs breaking 52-week price records, but both Fidus Investment (FDUS) and First Eagle Alternative Credit (FCRD) are within 5%. Two other BDCs trade between 5%-10% off their highs as well.

Heating Up

Furthermore, the number of BDCs trading above net book value per share has increased again this week to 14. A week ago the number was 13 and two weeks ago 12.

BDC earnings season, which still has a long way to go with 31 public players still to report, appears to be activating investors’ animal spirits.

This is giving new life to the BDC price rally that has been chugging along since mid-December.

Just using the S&P BDC Index on a price basis, the sector is up 11% over the last 9 weeks. Using the BDCZ data, 7 of those 9 weeks have seen the sector in the black.

YTD in 2023, 37 BDCs are up in price.

This is not one of those BDC rallies that includes everything and everyone but the kitchen sink, but it’s close.

Contrast

Interestingly, the rally is occurring even as the leveraged debt credit picture darkens.

Those BDC managers reporting IVQ 2022 earnings and who’ve been asked about the outlook for credit in 2023 have not been bashful in promising some trouble ahead.

Here’s a little extract from how Ares Capital’s (ARCC) Robert DeVeer answered a question on this subject at a just-held “financial services” conference:

Derek Hewett

If at all, defaults and more importantly, severity are, to a certain extent, still somewhat topical. Now whether you look at defaults in the liquid credit markets or among the BDCs, they’re still trending near historic lows, although I suspect some of that just had to do with kind of the refi wave that we had in 2021. That being said, what is your outlook for defaults for the sector in 2023? And then…

Robert DeVeer

I think it would go up.

Bank Of America Financial Services Conference – February 15, 2013

Of course, Mr. DeVeer followed up by praising ARCC’s underwriting capabilities and indicating any increase in losses would be manageable.

A similar message was delivered by TSLX’s CEO on his conference call as part of his closing remarks:

…Rates for the foreseeable future will most definitely cause stress for certain borrowers, followed by an uptick in defaults from the historical low levels we’ve experienced more recently.That being said, we anticipate credit issues to be heavily related to borrowers with weaker underlying business models, and we are confident in the durability of our portfolio companies.

Sixth Street Specialty Lending – Earnings Conference Call – February 17, 2023

For the moment, investors – like BDC managers – are undeterred by the risks inherent in rates rising ever higher and stressing borrowers’ debt service capabilities.

From Both Sides

There’s also the possibility, still barely showing up in the IVQ 2022 BDC results but reflected in the most recent economic indicators, that a slowing economy will result in a double whammy for some borrowers of weakening EBITDA and higher debt service costs.

Up Next

We’ll have much more to say in the BDC Reporter’s Credit Report for the week which seeks to keep track of the most recent casualties and walking wounded, both relating to BDC-financed companies and those financed by other parties.

All we’ll say here is that the number of bankruptcies in the leveraged finance world continues to grow at a notable pace.

High Expectations

As we move forward in earnings season expect many more BDCs to report ever-better results like those of HTGC, TSLX, and most of the other players that have come so far.

Unfathomable?

What will be much harder to ascertain is just how bad credit conditions will get in the second half of the year as the Fed squeeze reaches its likely apex and economic conditions weaken further.

That is the key challenge for BDC investors, but it’s an unknowable wild card even for those of us who spend every day scouring through the universe of BDC-financed companies looking for trouble.

At the end of the day, BDC investors will have to do what homework they can and take a view and hope they’re right as this conundrum will be the dominant theme of 2023.