BDC Common Stocks

Week 21

Pattern

Two steps forward, one step back.

That’s the best way to describe how the BDC sector has performed price-wise since reaching its nadir in the higher-interest rate era back in late September 2022.

BDCZ – the exchange-traded note which owns only BDC stocks hit bottom on September 25,2022 while BIZD – the only BDC exchange-traded fund – was there a day later.

Since then, both these sector-tracking vehicles have been on an upward trend for 85 weeks, increasing in price by over 20%.

Hard Slog

However, it’s never been plain sailing.

Remember, the market meltdown late in 2022 when everyone became (almost) certain a recession was coming in 2023?

In fact, in 2023 the real gross domestic product (GDP) of the United States increased by 2.5 percent compared to 2022’s 1.9%.

Statista

BDCZ dropped about (6%) in less than a month, but revived around Christmas.

Disaster Strikes

Then – a few months later in the spring of 2023 came the failure of Silicon Valley Bank (SVB) and the short-term panic which ensued and knocked the BDC sector’s market capitalization down by about (10%) in a few days.

That fever broke after a few weeks but resumed in October 2023 – ironically because the markets became concerned that the economy was performing too well, ensuring high rates for longer across the board.

Although high rates – in most ways – are a boon to BDCs, the sector still dropped about (8%) but only for a month.

Turbulence

Since then there have been bumps along the way, but BDCZ has not strung together more than two consecutive weeks in a row in the red since.

That includes the last 2 weeks – Weeks 20 and 2021 of 2024 – which saw the exchange-traded note drop (0.2%) and (0.1%) respectively, although daily percentages were higher both up and down.

Too Quiet?

We’ve now been over half a year without one of those periods of doubt that can move markets; create buying opportunities for some and profit taking for other.

In fact, we’d characterize 2024 as “flat” where BDC prices are concerned.

BDCZ closed this week at $19.63, up 0.8% compared to its price on January 8, 2024 of $19.47.

That’s Okay

In other markets, “flat” prices tend to lead to investor hair pulling and teeth gnashing but not in the BDC sector, thanks to the requirement that they periodically distribute the bulk of their earnings.

Stable prices make for juicy “total returns” and as the year marches on this phenomenon only improves.

Here we are just before the unofficial beginning of summer – less than halfway into the year – and the sector’s “total return” – as calculated by S&P using both price change and dividends received) – is 9.7%.

That return mostly consists of income and remains within spitting distance of the S&P 500′s “total return” in 2024 so far of 11.9%.

If these “flat” price conditions continue, the accumulation of still very generous BDC distributions should result in a full year return in the mid teens – let’s say about 16%.

Relatively Speaking

That compares very favorably with the average annual 3 and 5 year return of the S&P BDC Index of 11%, and with the 10 year annual average of 8%.

That putative 17% 2024 return also beats out the S&P 500’s 5 and 10 year annual returns of 15% and 13%.

Which is all to say that what might seem like an un-inspiring first 21 weeks of the year could yet produce a superior year even if sector prices go nowhere from here.

Better Case

With all that said, there are scenarios where BDC sector prices could yet go higher even if 22 BDCs out of 42 are trading within 5% of their 52-week highs and 20 are trading at a premium to net book value per share.

As we were reminded this week when Saratoga Investment (SAR) announced its latest quarterly dividend increase, the sector is in the midst of a third year of very high payouts to shareholders, especially when compared with the 2020-2021 (almost literally) “zero interest rate” era.

Although BDC earnings in the IQ 2024 have mostly flattened out or dipped – by our count 10 were up versus the IVQ 2023, 1 was unchanged and 31 were down for an average decrease of (3.5%) – payouts remain very robust.

Hanging In There

Our sister publication – BDC Best Ideas – which projects out the likely dividends of almost every BDC, believes 2024’s total payouts will almost match 2023’s.

Even more controversially – and admittedly speculative given that no one knows where interest rates are headed – BDC Best Ideas sees payouts not moving downward much in 2025 either.

With so much for investors to look forward to and with most BDC net book values stable or growing; credit in good shape; liquidity plentiful and market conditions for new loans more favorable than in the years before 2021 one could see how investors might yet push up BDC prices yet.

Multiply

That would effectively expand BDC multiples, which are on the high-ish side but – in most cases – below previous highs.

Let’s put some metrics to that statement:

Using the highest closing price BIZD reached in the spring of 2022 and last 4 quarter of distribution ending in April of that year, we get a Price-To-Distributions multiple of 12.9x.

Doing the same sort of calculation now, the multiple is 9.6x.

Applying the 2022 multiple to BIZD’s current distribution power would increase its price – wait for it – to $23.0 a share from $17.04 as of Friday.

That’s a purely hypothetical and mathematical – but not unimaginable – 35% increase in the stock price of BIZD.

As we’ve noted before, BDCZ and BIZD would need to increase by only 5% to match the price levels they reached in 2020 and 2022.

On paper, though, BIZD – aka the BDC sector – could yet trend much higher.

Brake

What’s holding investors – and thus prices and multiples back?

Of course, that’s impossible to tell unless we polled every market participant and received a true answer from each.

Our suspicion, though, is that many investors expect BDC payouts to – more or less – round trip to their level in 2021.

Why pay up for an investment whose dividends will drop sharply in the years ahead even if the manager is doing everything right?

Believe It Or Not

Our view – as we’ve made clear – is that even if the Fed does reduce rates and SOFR drops to 2.3% from 5.3% today – is that BDC distributions will not drop all that much.

BDC Best Ideas projects BDC payouts – on average – will drop only (13%) by 2028 over their level in 2023.

A not inconsequential number of players are even projected to maintain or increase their annual payout over this period.

Ours is likely a minority view and might explain investor reluctance to pay up.

Never Far Away

In a related vein, there remains a suspicion amongst many investors that a recession could be around the corner, typically which the mere anticipation of is the kiss of death for BDC prices.

After all, private credit is seen as a cyclical industry and many investors don’t want to be around when the roller coaster begins its stomach turning downward descent.

We understand the reluctance and cannot argue against the possibility that – like a California earthquake – we might not be overdue for an economic reset.

Sustainable

However, we’re pretty sure that the BDC sector has fundamentally changed since the Bad Old Days of the Great Recession which was very traumatic for BDC investing.

Should a recession be visited upon us, we don’t expect BDC fundamentals to be anywhere near as challenged as was the case in 2008-2009 – the last time BDC investors faced The Big One.

As a result we don’t expect the permanent damage in terms of capital loss to be sufficient to require stepping away from the sector when the cycle turns unfavorable.

Nothing Lasts Forever

The BDC Reporter is undoubtedly being optimistic while the market remains more measured.

That stance may change in either direction for both. We may swap places or align.

As ever, we will be driven by our reading of the mounds of data we collect.