BDC Weekly Review: Early Third Quarter Results Suggest Sector Resilience

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Darren415

This article was first published to Systematic Income subscribers and free trials on October 14.

Welcome to another installment of our weekly BDC Market Review, where we discuss market activity in the Business Development Corporation (“BDC”) sector both from the bottom up – highlighting the people news and events – as well as top to bottom – providing insight into the wider market.

We also try to add historical context as well as relevant themes that seem to be driving the market or that investors should be aware of. This update covers the period up to the second week of October.

Be sure to check out our other weeklies – covering closed-end funds (“CEFs”) as well as the preferred bond/baby bond markets for insights across the entire income space. Also see our introduction to the BDC industry, with a focus on how it compares to credit CEFs.

Market action

BDCs managed to finish in the green this week despite continued high volatility across the earnings space. Most companies remain up so far in October after a tough September, with only the two high-value companies posting negative returns this month.

Systematic income

Systematic income

The theme of the strong underperformance of high-valuation BDCs remains in play in the currently weak market and highlights the danger of chasing the “winners” in a strong market.

Systematic income

Systematic income

The valuation of the BDC sector has stabilized around previous lows outside of the GFC and the COVID crash. We don’t expect the sector’s valuation to approach these lows (i.e. a 40% valuation trough) as the current macro picture appears to be a traditional Fed-induced recession rather than an existential crisis for the economy and the markets.

Systematic income

Systematic income

Market themes

We have yet to fully enter the third quarter reporting season for the BDC sector, however, there are early indications that the sector is holding up quite well.

First, in recent weeks a number of BDCs have increased their dividends. These include TRIN, CSWC, GAIN and GLAD while WHF declared a new special dividend. Continued dividend increases are not unexpected in an environment of rising short-term rates – much of the sector also increased its dividends in the second quarter.

However, perhaps more important is the fact that higher dividends also indicate that the sector’s portfolio quality is not falling off a cliff. After all, if non-accruals, PIKs, or defaults increased during the third quarter, companies would be highly unlikely to increase their dividends.

Second, we have also seen the first indications of NAV estimates. The SAR, which has already released official numbers, saw a 1.5% decline (of which 0.35% was due to the extinguishment of the bonds) – this is much better than the decline in Q2 and weaker than the average decline in BDC’s net asset value in Q2. CSWC announced an estimate of its net asset value whose midpoint is only slightly lower than its level in Q2. Although this remains anecdotal, it is another sign that we are not seeing a sharp decline in portfolio quality in the sector.

We most likely haven’t gone through the full market pullback yet, but the fact that in the middle of its tenth month the sector remains relatively resilient is a good result for BDC investors.

Market Commentary

Golub Capital (GBDC) said it generated $177 million in new investment and the fair value of its portfolio fell 3%. Unfortunately, that doesn’t tell us much. We don’t know how many prepayments there have been, so we don’t know what the net number of new investments is. That said, it is very likely to be negative based on its previous prepayment rate shown in the table below. The 3% drop in the portfolio makes the net asset value look much lower, but that could be entirely due to the drop in net new investments.

GBDC

GBDC

Capital Southwest has released preliminary estimates for the third quarter. Q3 net profit increased 5.5% quarter-on-quarter and Q3 NAV estimate was flat in Q2. Overall, this is a very good result for the sector. It will be interesting to see how the change in NAV breaks down into unrealized depreciation (i.e. wider credit spreads), prepayment charges and an increase in NAV from sales on the market. The increase in ATM sales is expected to be small given that the CSWC premium has completely collapsed from 175% to 101% and prepayment fees are also expected to be quite low as prepayments tend to drop when costs funding increases. This suggests that latent depreciation is low, which in turn suggests that portfolio quality should hold up well across the sector.

BDC Systematic Income Tool

BDC Systematic Income Tool

Gladstone Investment has increased its regular dividend by almost 7% – the total dividend increase is 3% more modest given its supplement which will also be paid in December. The company is a bit of an industry oddity due to its undiversified portfolio and large preferred stock allocation. Its net income is also well below its total dividend, although its total value creation has reached a very high level, as shown in the graph below. GAIN is trading at a valuation of 91% or 5% above the industry average and a total dividend yield of 11.8%.

BDC Systematic Income Tool

BDC Systematic Income Tool

Position and takeaways

We continue to see value in the BDC sector thanks to its rising net income, seemingly resilient net asset values ​​and attractive valuation levels. We continue to see value in names like CGBD, GBDC and FDUS held in our high income portfolio in absolute and relative terms (i.e. in terms of valuation against the sector) and would consider opportunistically add names like ARCC and GAIN for further weakness.

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