BDC Common Stocks

Week 5

Curious

The Federal Reserve governors gathered as planned on Tuesday-Wednesday of this week and agreed to do nothing once again where interest rates are concerned.

Furthermore, at the lectern on the final day Chairman Powell all but ruled out a rate decrease in March, frustrating the 63.5% of market observers who have stubbornly believed that’s when the first rate cut is coming, despite all the evidence to the contrary.

All of this was confounding to the major indices – and to the BDC sector – whose prices fell sharply.

BDCZ – the UBS-sponsored exchange-traded note which holds only BDC stocks – fell (2.8%) on Wednesday and Thursday in the biggest pullback we’ve seen all year.

Although investors pulled themselves together on Friday, BDCZ was down (2.3%) for the week as a whole, closing at $18.70.

The ETN ended down (1.4%) year-to-date but the S&P BDC Index on a price basis was up 0.94% and 1.07% on a “total return” basis.

Best Of Times

The irony in all this is that higher rates for a little longer; a strong economy and low unemployment are all good for the BDCs and their shareholders.

The Fed’s non-moves are in line with the projections we’ve made in BDC Best Ideas that there will be no rate cuts till June at the earliest.

This all but guarantees at least two more quarters of record-high loan yields – and profits – for the BDC sector.

Even the back half of the year promises rate levels better than those in 2022 and might allow 2024 as a whole to be the best year yet for the BDC sector since the Fed began its inflation fight.

Damage

Anyway – rightly or wrongly – the mid-week run for the exits by some investors – caused 37 BDCs to drop in price and only 6 to remain unchanged or increase.

(There was one new BDC at a 52-week price high during the week – Main Street Capital (MAIN) – but that occurred before the Fed announced its do-nothing intentions).

8 BDCs dropped in price by (3.0%) or more in this week’s panic.

Worst

The Biggest Loser – and the only one of the Unlucky Eight to have reported their IVQ 2023 results – was Oaktree Specialty Lending (OCSL), down (8.4%).

The BDC Reporter – and our sister publication the BDC Credit Reporter – have spent a good deal of time with the BDC’s 10-Q, conference call, and investment presentation since their publication and we have to agree that investors had reasonable cause for concern.

As is almost always the case when these sudden swooning fits happen, the central reason was poor credit performance.

Just a few weeks ago Saratoga Investment (SAR) added one new non-accrual to its books and ended up losing a tenth of its market capitalization.

OCSL – admittedly nearly three times larger in terms of portfolio size and companies – reported 4 new non-accruals.

Management admitted that the loss of income from new non-performers brought down the BDC’s Net Investment Income per share by ($0.04) per share – or about (6%) of recurring earnings by our count.

In The Weeds

Over at the BDC Credit Reporter, we systematically delved into every non-accrual as well as the principal realized loss for the quarter – a restructuring that caused Continental Intermodal to return to performing status.

(All the Credit Reporter’s articles can be found in the BDC Publications News Feed in Investor Tools. A couple of those articles have been made available to all readers in a shameless attempt to solicit new subscribers interested in knowing what is happening in the opaque world of underperforming BDC-financed companies).

There are two hard truths to emerge from our research: much of OCSL’s capital tied up in the non-accruals is likely to be permanently lost and further write-downs are likely.

Investors should keep a special eye on Impel Pharmaceuticals which had been under bankruptcy court protection with $127mn of reported debt outstanding and was just sold for $17.5mn.

The outlooks at “Amazon aggregator” Thrasio and at the Singer Sewing Company both look bleak and airport concessionaire OTG Management appears to be about to become a “Control” investment of Oaktree’s.

The loss of investment income due to non-accruals and from the Continental Intermodal restructuring is likely to be permanent, especially given that there are numerous other underperformers in the portfolio.

By our standards, OCSL is moving over that invisible line of “normal” credit challenges to something more worrying.

What They Do

Thankfully, Oaktree does consider itself a master at dealing with distressed situations and extracting long-term value even in the most difficult situations.

OCSL’s managers will be kept busy as we can identify half a dozen companies that will require special care and attention in 2024.

The only good news we can offer at this stage is that of the 25 underperforming companies identified by the BDC Credit Reporter none were added to the list in the IVQ 2023.

All of OCSL’s troubled names have been around in some degree of distress for some time.

Outlook

Notwithstanding the Wednesday-Thursday price meltdown, we’re not ready to call an end to the now-long-in-the-tooth BDC rally.

There was a price rebound on Friday and 16 BDCs continue to trade at a premium to net book value.

Furthermore, 32 BDCs continue to trade within 10% of their 52-week highs, in line with what we’ve experienced for many weeks now, even if the proportion within 5% has dropped.

Investors – or their algorithms – are quick to take profits at any sign of stress.

Admittedly, there are currently 4 BDCs trading within (10%) of their 52-week lows where previously there was only 1, but – by itself – that’s not a sign of a sustained price pullback.

These Things Matter

With BDC earnings season getting into full swing in February, how fundamentals play out may determine where the sector heads from here.

SAR and OCSL have amply demonstrated that when you’re flying high price-wise, investors are not forgiving of any misstep.

A glance at the BDC Earnings Calendar – yet another Investor Tool we offer – shows that 6 BDCs are reporting results in this coming week, including market leader Ares Capital (ARCC).

We’re not getting foreboding feelings about any of the names, but one never knows.

Could Happen

The “bull” case is that BDCZ has 10% further to run to match its level in the spring of 2022, just before EVERYONE thought a recession was a sure thing and the level to which interest rates would give rise to stop inflation was unknown.

Nearly two years later, there is no recession in sight – not even a slowdown in GDP growth by most accounts – and we have some sense that rates have peaked and will be headed southward in some form and fashion.

Furthermore – going by BDCZ’s quarterly distributions – the sector is paying out 17% more in 2024 than in 2022.

These are – as has been said before – Goldilocks conditions for BDCs and only a spate of worrisome individual results like those from SAR and OCSL should keep the BDC party from going on late into the night.