BDC COMMON STOCKS

Week 40

Stranger Things

This was an unusual week, led by huge moves in the bond market that every headline writer called “historic”.

Yields reached their highest level since 2007 when we heard – once again – that the U.S. economy continues to generate plenty of jobs and (modest) payroll growth.

This is read by the market as implying that the U.S. economy continues to expand and – ergo – the Fed will be either keeping short-term rates high or might even raise them further.

There’s now a 44% chance there will be a 0.25% rate increase in November.

The result of all this is a very strange situation where the markets are concerned about the economy’s strengths now and presume this will bring about a recession later, as those higher rates are expected to crush us by next year.

The bond market was in a “rout” throughout the week.

Most everyone in the financial community projected stocks – facing competition for investor dollars from those juicy yields and that inevitable recession – expected to follow.

In fact, by Friday the S&P 500 was up for the week and so was the NASDAQ while the Dow Jones was only off (0.3%) – record bond yields notwithstanding.

This surprised many traders and commentators.

Maybe common stock investors recognized that full employment and a strong economy – especially when Europe and China are struggling – trump everything else.

Left Behind

Unfortunately, the BDC sector did not get the memo till late in the week.

Over the 5 days, BDCZ – the exchange-traded note that owns most BDC stocks – dropped (3.0%).

That was the second-worst percentage price decrease for BDCZ in 2023.

Relatively Speaking

However, that sounds worse than it is. The worst week of 2023 was back in March when Silicon Valley Bank (“SVB”) went kaput and triggered a (9.9%) drop in BDCZ.

This week’s retreat was far more mild.

Back in the SVB aftermath, all 42 BDC stocks dropped. This time, 5 BDCs even posted an increase.

To put this into perspective, this week’s pullback brought BDCZ back to its level on August 25, wiping out September’s gains.

The highest price reached on an intra-day basis last month was $18.56. With BDCZ closing at $17.90, the maximum drop amounts to (3.6%).

At this point, BDCZ remains 7.1% up in 2023, and the total return S&P BDC Index is 16.9% in the black.

28 BDCs have increased in price this year – two-thirds of our coverage universe.

Pretty, Pretty Good

What was panning out to be an excellent year for the BDC sector where investor returns are concerned has slipped to very good after 40 weeks.

If BDC stock prices remain unchanged for the rest of 2023, the remaining dividends to be received will almost certainly carry the total return to over 20%.

By way of contrast, the total return for the S&P 500 is 13.7%

Outlook

If you check out, the trend in analyst earnings estimates for most BDCs over the last 90 days – as we’ve been doing – you’ll see that the numbers are growing.

Both for the remainder of 2023 and next year, the consensus amongst the many firms that cover this sector is that recurring earnings are going even higher than they’ve been.

We’ve known for some time that 2023 would be a bumper year for earnings and dividends, but this suggests an even further raising of the bar.

Clearly, the analysts are believing the Fed and are adjusting their models for higher rates.

Some Way To Go

More controversially, the BDC Reporter believes “peak earnings” are several quarters away and that 2024 should exceed 2023 by the time we get there.

BDCs will benefit from the Fed’s high rates and the underlying portfolio companies will – in almost every case -be boosted by the strong economy that the employment numbers are suggesting.

Essentially, that’s what’s been happening since early 2022, and there’s no end yet in sight.

Few Casualties

The fear that many investors and analysts had that leveraged companies would not be able to handle higher debt service costs has not played out. Most portfolio companies have seen their sales and EBITDA boosted by inflation and the expanding economy.

As a result, only a small number of borrowers will be seriously impacted by another 25 or 50 basis point increase in short-term rates and/or a longer tenure at these elevated levels.

Don’t take our word for it, that’s what many BDCs are saying after running through their portfolios.

Credit Impact

We won’t steal the thunder of our weekly Credit Recap, but we will say that unless there’s a sudden increase in new underperforming companies, the bulk of BDCs will also not be materially impacted earnings-wise by bad debts from other causes.

The industry’s credit performance where underperforming assets and non-accruals are concerned has remained well within a normal range all this year.

BDC earnings season for IIIQ 2023 is only a few weeks ago, and we’ll be able to test this rosy outlook for fundamentals before long.

Psychology

What we don’t know is whether the panic that gripped BDC investors early in the week – even though the news was largely favorable to their interests – will recede.

For the moment – and despite this week’s panic – the BDC rally that began on April 6, 2023, keeps on going as BDCZ did not drop (5%) or more from its recent closing high.

Looking Up?

Was last week the beginning of the end or just a bump along the way to even higher heights?

After all, BDCZ needs to increase 15% just to match its 2022 high point, set at a time before anyone knew how high rates – and BDC earnings – would go…