BDC Weekly Review: We Are Moving Past The Goldilocks Phase

This article was first released to Systematic Income subscribers and free trials on Apr. 29.

Welcome to another installment of our BDC Market Weekly Review, where we discuss market activity in the Business Development Company ("BDC") sector from both the bottom-up - highlighting individual news and events - as well as the top-down - providing an overview of the broader market.

We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the last week of April.

Market Action

BDCs had a decent week as both Treasuries and stocks rallied on the week. Risk sentiment has been supportive due to better-than-expected corporate earnings and good reports from BDC specifically.

Sector valuation has crept up towards 93% which is roughly in the middle of its range this year and about 8% below the longer-term average. This looks to be around fair value in our view given the number of challenges on the horizon.

Market Themes

Our view this year has been that we will be moving past the Goldilocks phase for the BDC sector after Q1. In this Goldilocks phase net income grew rapidly as a result of sharply rising short-term rates while portfolio quality remained robust as the macro picture held up well even as the economy was clearly slowing.

Now, this Goldilocks phase is coming to an end in our view. Net income rises are likely to slow down in Q2. We can gauge this by looking at the path of Libor in the chart below. Specifically, we see that the trajectory of short-term rates slowed down considerably last December. Because short-term rates are passed through to income with a significant lag, we can expect Q1 net income numbers to come in pretty strong. However, Q2 numbers are unlikely to rise much above their Q1 levels.

There is some disagreement over the future path of short-term rates. The market thinks short-term rates will peak imminently and start to fall at a quick pace while the Fed thinks short-term rates will remain stable this year and then start to fall next year. In any case, unless both are wrong we can expect sector net investment income to peak sometime this year or early next year.

Very few BDCs have reported so far. However, if we look at Ares Capital Corp (ARCC) which has, we see that while portfolio yield increased by 1% on average for Q3 and Q4 it increased by only 0.4% over Q1 and this increase will be even lower in Q1 in our view.

The second element of the end-of-Goldilocks view has to do with portfolio quality. Specifically, portfolio quality is likely to worsen at a quicker pace from here on if the economy continues to slow down as we expect. Q1 GDP surprised to the downside the other day, leading indicators continue to fall and bank loan defaults have increased.

Taking another look at ARCC, non-accruals at cost have risen after being flat for a couple of quarters while its net realized losses have increased to a 3-year high as well.

None of this means that BDC investors should run for the hills, particularly as valuations have come off their pre-March levels. At the same time, however, investors shouldn't assume they can enjoy the same kinds of net income gains or stable portfolio quality they have seen over the past year. This stabilization in net income may also remove a key price support for the sector, making sector stocks more vulnerable.

Market Commentary

Capital Southwest (CSWC) increased the regular dividend by a penny to $0.54 and redeclared the $0.05 special. The company provided guidance earlier of its net investment income of $0.63-0.64 so not a big surprise and net income is still comfortably above the dividend. The stock jumped 5% on the day which tells us that people aren’t really paying attention to anything except actual dividend declarations even if they are highly probably ahead of time.

Ares Capital Corp net investment income fell to $0.57 from $0.63 despite a continued increase in base rates. The key drivers of the drop in income was the big drop-off in fees likely due to a lower level of prepayments (from a subdued level of deal activity in Q1 vs. Q4 which benefited from year-end seasonality) and a sharp drop in leverage. Leverage fell to 1.1x from 1.3x primarily driven by a low level of new investments (apparently as a couple of large deals fell away) and recent equity issuance. The dividend remained unchanged at a pretty conservative $0.48.

Stance and Takeaways

In line with our end-of-Goldilocks view, we will continue to sell rallies in the BDC sector as we did when the sector moved out to a clearly expensive valuation at the start of March. However, now that we have built up some dry powder we would not hesitate to add to our sector positions once again if valuations move back towards attractive levels. Unlike some investors, we don't view BDCs as uninvestable just because the probability of recession has risen. Everything depends on valuation and if sector valuation moves back towards the levels we saw in October of last year we would not hesitate to add new capital to the sector.

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