This article was first published for Systematic Income subscribers and free trials on March 25.
Welcome to another installment of our Weekly BDC Market Review, where we take a look at market activity at Business Development Company. sector from bottom to top, highlighting individual news and events, as well as from top to bottom, providing an overview of the market as a whole.
We also try to add some historical context as well as relevant topics that seem to be driving the market or that investors should be aware of. This update covers the period up to the fourth week of March.
Be sure to check out our other weeklies – Covering the CEF as well as the baby/preferred bond markets for insights in the broader income space. Also, take a look at our primer of the BDC sector with a focus on how it compares to credit CEFs.
CDBs had a very strong week with a 2% total return, trailing only MLPs and utilities with only three companies posting negative returns. Month to date, USDF and HE PASSED stay ahead thanks to strong earnings announcements and dividend increases.
March is shaping up to be a decent month after the flat months of January and February. CDBs have mostly ignored the recent surge in Treasury yields, most likely due to the rally in stocks, as well as rising short-term yields that are expected to boost CDB earnings in the coming quarters.
So far this year, all of our BDC entries are in the green so far, with 4 of our 6 total entries in the top 8.
With earnings season behind us, it is interesting to take a look at the NAV’s return trend. Our expectation at the end of last year was that the NAV return trend would continue to decline and this is indeed what we saw in the fourth quarter. That said, the average NAV still managed to rise above 1% for the quarter, generating around a third of the sector’s total return for the period. Looking ahead, we expect this downward NAV return trend to continue. This is due to recent weakness in broader risk assets and its impact on asset valuations, as well as a reduced number of portfolio exit opportunities (via IPOs or mergers and acquisitions) and the reduction in supply chain. advance payment fees.
Investors who follow the BDC market fairly closely have likely noticed some unusual behavior at Ares Capital Corp (ARCC). The company’s fourth quarter results were very strong, delivering a total NAV return of 4.6% vs. the industry average of 3.8% and the median of 3.0%, continuing its track record of outperformance . The company also increased its regular dividend and also declared a special dividend.
So, of course, the stock proceeded to drop sharply. The graph below shows ARCC’s price over the past year with the red lines showing the quarterly results announcement dates. The arrow points to the most recent fourth quarter earnings announcement. This is not explained by any broader and more obvious market movement. While the recent market environment has been challenging to say the least, the rest of the BDC sector has held up well to date.
Interestingly, over the past year, stocks moved sharply lower after the announcement, each of which was quite strong. So why are we seeing such strange behavior where stocks go down despite positive news?
A flippant response would be that this is just an example of “buy the rumour, sell the news”. The market has learned to expect strong results from ARCC and knows how to pre-position for it, dumping the stock after the news breaks. The chart below shows that ARCC has delivered fairly consistent NAV growth over time, with an average quarterly NAV increase of around 0.6% or around 2.5% annualized. This trend has been even stronger in the post-COVID period.
If we look at the historical price movements on the announcement dates in the chart below, we see that the ARCC price has tended to recover from generally positive results with the average and median daily performance well above what they should be in a perfectly efficient market (ie they should be pretty close to zero on those days). However, what the chart also shows is that these bounces have been more random and less reliable recently.
This technical dimension seems a likely culprit for this strange behavior. However, a related reason this has happened is for the simple reason that the company’s valuation has tended to rise quite a bit before its announcement. Whenever this happens, it leaves much less room for safety for investors, even if the results are good.
The key takeaway here for the broader CEF sector, and particularly for those CDBs that have shown consistent returns above their returns, is that, absence of an increase in valuationBuying a few more shares in a BDC like ARCC a few weeks or days before earnings is a very sensible thing to do, both for the more tactical and buy-and-hold investors. In large part, this is because valuation will likely be slightly understated on average for those BDCs that have historically generated a steady rise in NAV, offering an attractive entry point for a marginal allocation.
Capital of the Trinity (HE PASSED) increased its dividend at the end of the previous week by 11% to $0.40 and declared a complementary dividend of $0.15. That equates to a total dividend yield of 11.15% based on the price at the time of this writing.
The company’s NII has only risen above $0.40 once in the last 7 quarters, so this is more a reflection of the company’s recent ability to generate unrealized earnings.
TRIN has one of the highest equity/warrant allocations (twice the average BDC), which goes a long way to explaining its strong NAV performance. We have seen a very similar dynamic at FDUS. It is no coincidence that in a period of strong public equity returns, FDUS and TRIN had two of the best fourth quarters in the industry with quarterly total NAV returns of 11.3% and 14.1%.
Golub Capital’s CDB (GBDC) valuation has moved lower to a 98% valuation the other day before rising slightly to 99% as of this writing. GBDC’s valuation has lagged the broader sector over the past year, although it has tended to stay above 100%. Over the past few years, GBDC has tended to boast a higher valuation relative to the sector, as the chart below also shows.
GBDC is generally considered a boring, high quality, low capital allocation BDC. You also benefit from a very low interest cost of debt and a cheap administration fee structure. Recent total NAV returns have been below the sector average, primarily due to low equity allocation and poor asset performance (a likely indication of a stronger credit profile). NII has been growing steadily and coverage is above 100% which should allow them to raise the dividend in the medium term back to the pre-COVID level. The current valuation gap of close to 10% is historically unusual and we expect this to close, particularly if the equity market remains weak. GBDC is trading at an 8% dividend yield.
Posture and takeaway
Chairman Powell’s recent commentary in favor of possible 50bp hikes (and their positive impact on BDC’s earnings levels), as well as the recovery in equity markets, have continued to support the sector. The key question for the CDB sector is whether the Fed’s recognition of the inflation problem and its willingness to tighten too much to solve it will lead to a recession. And while the BDC sector generally did well during the brief recession of 2020, a more traditional extended downturn could affect company earnings, particularly as they may also be affected by higher interest costs due to the rise in Libor, the base rate for most BDC loans. This may lead to higher non-accruals and ultimately portfolio losses in the sector. This risk of prolonged recession remains key for investors in the sector.
For this reason, we think it makes sense for investors to hold some allocations to BDCs that are likely to remain more resilient during a downturn like GBDC, as well as OCSLboth attractive with valuations below 100% or below $15.40 and $7.40 respectively.