BDC COMMON STOCKS

Week 48

Zoom

Investors everywhere were grateful over the holiday-shortened week.

This included those invested in the BDC sector.

BIZD – the exchange traded note which owns most of the public BDC stocks – outstripped the major indices in terms of percentage price gain – up 1.7%.

The S&P BDC Index – on a price basis only – increased by that same percentage.

On a “total return” calculation – which includes dividends – the S&P BDC Index was up 1.8%.

Likewise, most of the individual BDCs we track increased in price or were unchanged – 36 out of 42.

Furthermore, 6 BDCs increased by 3.0% or more while only 1 fell (3.0%) or more in price. That was PennantPark Investment (PNNT), whose results failed to excite.

The number of BDCs trading at or above net book value per share remained at 15.

So Many

The most notable metric of the week were the number of BDCs reaching new 52 week highs.

We count 6.

Mostly, this consisted of long-time investor favorites like Ares Capital (ARCC); Barings BDC (BBDC); Blackstone Secured Lending (BXSL) and Main Street Capital (MAIN). (That last name keeps on going from peak to peak).

Also breaking price records were SLR Investment (SLRC) and Logan Ridge Finance (LRFC).

Sidebar

The former reported “another quarter of stability and ample dividend coverage” a few weeks ago.

“Ample” seems to mean earnings coverage of about 10%.

Not to be a wet blanket, though, the analyst community projects 2025 earnings will be $1.64 per share, exactly equal with the current $1.64 in distributions, paid out $0.41 a quarter.

Exceptional

LRFC is still on the sugar high of having sold its equity position in portfolio company Nth Degree, intending to re-deploy the proceeds into income-producing investments.

Over at BDC Best Ideas we’ve been updating the analyst earnings estimate for every BDC in 2025.

This tiny BDC is notable for being the ONLY BDC that is projected to increase its recurring earnings per share in 2025 over the likely 2024 level.

Everybody else – regardless of portfolio size; market segment addressed or unused leverage capacity – is projected by the analyst community to see their earnings drop.

For all 41 BDCs we track at BDC Best Ideas, earnings are expected to drop by (10%).

Even in 2024, using the 9 month actuals and gluing on the analysts IVQ 2024 earnings expectations, only 5 BDCs seem likely to beat their 2023 result.

At the moment, 2024 earnings are projected to drop by (8%) over 2023.

Funny Peculiar

This data – drawn from the collective consciousness of the many analysts who spend every waking moment predicting future BDC results – makes all the more surprising the run-up in BDC prices that has occurred since the election.

Clearly, investors everywhere all at once have decided we are getting higher inflation for much longer and – thus – higher interest rates and – thus – higher BDC income than was previously anticipated.

Since the election, the S&P BDC Index has risen 6.4% on this now universal assumption, bringing most individual BDC prices along for the ride.

Not So Fast

However – in our self designated role of wet blanket – let’s not forget there is more than one factor impacting BDC earnings even if the Fed Funds rate drops only (0.5%) in 2025 rather than the (1.0%) previously expected. Click here for an article and video on this hotly debated subject.

Or even if the Fed Funds rates drops not all next year as some are predicting. Here’s Deutsche Bank’s economist on the subject.

Shout Out To Elizabeth Barrett Browning

Let us count the ways BDC earnings could be laid low:

1. Spread compression.

For over a year – on every conference call – we’ve heard about how loan spreads on new loans being booked are tighter than when EVERYONE (except BDC lenders presumably) was expecting a recession. We also know that “spread compression” from those halcyon days of not very long ago varies by market segment and by BDC.

What some people forget – even if spreads narrow no further (which is debatable) – is that the impact on BDC earnings is cumulative – like a snowball rolling down a mountain gathering size and speed as more and more of the richly-priced loans of 2022-2023 get replaced.

With every passing quarter more thinner spread loans get added and the overall portfolio yield on income-producing investments declines.

We’re only halfway or so down the mountain and – even if rates stay the same – those aggregate yields will shrink.

Sometimes not even a refinancing is required for this to happen. A popular borrower just has to give its lenders the evil eye and spreads get quietly adjusted – something the BDC managers are not keen to talk about for fear of emboldening other borrowers.

Nasty

The Great Spread Shrinkage is of much more impact on BDC P&L’s than interest rate decreases.

After all, a lower Fed Funds rate can also mean a reduction in borrowing costs. Spread reduction does not.

The only benefit for BDC shareholders is that they’ll pay a little less in incentive fees but still pay full freight on management fees even as lower spreads reduce return on assets by up to (15%-20%).

With a lot of “private credit” chasing a limited pool of existing debt, borrowers are – once again – in control, except for the worst performers.

2. Borrowing Costs

As we all remember, back in the zero-interest days of 2019-2021 some BDCs were able to borrow on an unsecured basis, with no meaningful covenants, at yields lower than some sovereign nations.

All BDCs – whatever their size or historical performance – could at the very least tap the Baby Bond market or institutional lenders for inexpensive junior capital on remarkable terms.

Never fond of relying too much on the banks for their secured borrowings virtually every BDC made the argument that they were better off borrowing 50%-100% of their debt needs from the unsecured note markets, typically with a 5 year maturity.

This was cookie-cutter debt, each issue looking very much like the other, with the only difference being what interest rate was charged.

Historic

Billions and billions of dollars were issued in what we believe has been one of the most progressive developments in the BDC sector over the too many years we’ve been an observer.

31 of those issues are still present in the BDC Fixed Income Table but there are many, many more privately placed with institutional debt investors and out of the hands of the individual investor.

The problem now is two-fold. First, the BDCs want to continue to borrow on an unsecured basis and with few covenants. (Who wouldn’t?).

Second, the super cheap debt of five years ago is coming due and replacing like with like is expensive because – irony alert! – interest rates are still pretty high and not likely to get much cheaper.

Here’s an example torn from the relatively recent headlines: Golub Capital (GBDC) on April 8, 2024, redeemed $500mn in aggregate principal amount of its 2024 Notes, yielding 3.4%.

In recent days, the same BDC issued new unsecured notes due – of course – in 2029, paying a yield of 6.0% per annum.

Just Not The Same

Don’t get us wrong. That’s a remarkably “good” yield in this rate environment, even better than the yield paid by other recent BDC debt issuers FS-KKR Capital (FSK) – 6.125%- or CION Investment (CION) -7.50%.

However, the new debt costs nearly twice as much as the 2024 Notes. GBDC has other debt coming due in 2026 with a yield of only 2.5%.

No Way Out

Sadly, the BDCs don’t even have the choice of going cap in hand to borrow from the banks to save themselves a few interest expense dollars.

An all-in Revolver, especially when unused line fees are considered, cost 6.5%-7.0% per annum for the very best BDCs and a lot more for the smaller and/or weaker players.

With short term and medium term rates POSSIBLY not going much lower in 2025 and beyond – these are long term trends after all – there may be no solace ahead for BDC CFOs.

With every passing quarter, more and more of the inexpensive debt matures and passes into memory and new, much more expensive debt gets locked in for 2-5 years, squeezing away at BDC profitability.

3. Credit Losses

Admittedly, this is obvious but let’s discuss the subject anyway.

In the last couple of quarters, credit losses – whether realized or unrealized – have begun to increase on BDC books.

Look at the NAV Change Table and you’ll that in the IQ 2024, 23 BDCs reported that their Net Asset Value Per Share (NAVPS) increased over the prior period. However, in the IIQ 2024, that number dropped to 13 and in the most recent quarter to 12. (We’re just waiting on PhenixFin – PFX).

It’s not that BDC’s credit performance is bad. In fact, the opposite has been true during these Golden Years – distressed credit has been lower than the historic average. (We are painting with a broad brush here).

However, there is that gut wrenching “reversion to the mean” going on.

Not Holding Back

Ares Capital (ARCC) – admittedly not a disinterested commentator – had this to say on the latest CC:

Across our markets, we have seen credit dispersion start to emerge with certain other managers experiencing growing and elevated levels of non-accruals. 

Tough But True

Recently, we’ve seen a significant number of BDCs stumble from a credit standpoint, in fact so many that we’ll refer to them by their tickers:

In venture debt, there is TPVG and HRZN. In the lower middle market there is OFS and WHF. In the middle market we count GSBD, OCSL, PTMN and TCPC and amongst what we call “hybrid” players there is GECC, OXSQ and – notably – PSEC.

That’s 11 BDCs – a quarter of the market.

Also a number of other BDCs have had significant credit scares which may be a short-term hiccup or something more sinister. On that list we’d place CION, CSWC, GBDC, MFIC and SAR.

Finally, and going against the consensus, we’re not as certain as the market that credit conditions are turned around at FSK, ICMB, LRFC and MRCC.

For what it’s worth, that’s 20 BDCs causing us to reach for our indigestion pills in the midst of record low unemployment; a strong economy and at a time of plentiful liquidity.

Closing Thoughts

Everyone loves a rally – except those of you on the sidelines – but maybe investors – thinking they are looking far down the road – are not.

BDC Best Ideas estimates that 29 BDCs will cut their total payouts in 2025 over their level in 2024.

Should this be correct, will the market continue to hold strong as BDC after BDC “right-sizes” itself?

We leave the answer to our readers.

Where We Are

After that long detour, let’s see where the BDC sector stands with just 4 weeks to go in the year.

BDCZ is trading just (4.2%) beneath its 2024 high, with exactly half the BDCs up in price on the year.

The S&P BDC “total return” in 2024 sits at 15.7%, which is impressive and way above the long term BDC historical returns (a subject we recently discussed at too much length in BDC Best Ideas).

However, we can’t help comparing the BDC total return to the S&P 500’s performance by this same tric, which is 28.1%!

15 BDCs are trading within 5% of their 52 week highs and 8 between 5%-10%.

Still, 6 BDCs are within 5% of their 52 week lows, including WhiteHorse Finance(WHF), which reached a new nadir this week.

8 BDCs are 5%-10% of their lows.

The truth of the matter – looking at the data and trying to be as objective as possible – is that the BDC performance metrics are still considerably behind the 2024 peak period in July.

To use our doughty cycling analogy – a break away group of good or “better than we anticipated” performers has pulled away from the peloton.

With little news to come between now and singing “Auld Lang Syne”, it’s hard to imagine much change in the last 4 weeks of the year.