This article was first published to Systematic Income subscribers and free trials on August 6th.
Welcome to another installment of our weekly BDC Market Review, where we discuss market activity in the Business Development Corporation (“BDC”) sector from a bottom-up perspective – highlighting individual news and events – as well as the top-down – offering 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 first week of August.
Be sure to check out our other weeklies – covering CEF as well as prime/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.
BDCs were the best performing income sector we track this week with a gain of around 1.5%. Good earnings reports, stable credit spreads, higher equities and higher short-term rates all supported the sector.
Year-to-date returns are quite scattered, however, the average total return of around -4% is quite strong in the broader income space.
The BDCs have continued to come out of their hole and they are already halfway there.
The average reported net asset value is down about 2.5% so far in the second quarter, reflecting the wider credit spreads we have seen in the second quarter. On a mark-to-market basis, however, this would likely be closer to a decline of around 1.5%, as credit spreads have tightened significantly since the end of the quarter.
The sector’s average valuation has rebounded strongly towards its historical average, with the entire sector fairly priced on this metric.
One of the most eagerly awaited data of BDC’s current earnings season concerns the evolution of net income across the sector. Significantly higher short-term rates should, at least in theory, lead to higher BDC income levels given that the average BDC holds approximately 90% of its holdings in floating rate securities. The fact that on average about 60% of BDC’s liabilities are fixed rate also helps, even if 100% of its liabilities were floating rate, net income would still increase with higher short-term rates, all things otherwise equal.
However, theory and practice do not always align, so here we take a quick look at the evolution of net income levels for the BDCs that have reported so far. The graph below shows the quarterly change in net income (blue lines) with the average of this measure indicated by a gray line. It also shows the change in net income from the average for the last twelve months (orange lines) with the average of this measure as a yellow line. We use basic or adjusted net income if reported and GAAP net income otherwise. The graph is cropped at +-20% for clarity.
What we see are two things. First, there are a lot of discrepancies – a lot of increases in net income and a lot of decreases. This makes sense because there are many other revenue drivers than short-term rates and different BDCs are exposed to these other drivers in different ways. The second thing we see is that the average quarterly change in net income was slightly negative at -0.6% (median was -1%). The change in the second quarter compared to the average of the last twelve months was -3.1% (the median was -1%). Overall, we can conclude that the net income is stable or slightly lower compared to its recent past on average.
This may come as a surprise to investors who were expecting a sharp rise in net income, but there are two key elements at play. First, the actual level of Libor that was used to accumulate coupons during the second quarter was not not particularly high. We estimate this level at around 1% versus 2.8% where the Libor is today. A Libor level of 1% is also roughly the average Libor floor, which means that BDC assets did not benefit much from the rise in Libor from zero to 1%, but were somewhat affected. on the liability side where there are no Libor floors. In other words, BDCs have only begun to emerge from the NII Valleyas we call it, in the third trimester.
The second key factor behind the slight decline in net income so far is that prepayment charges were very high in the fourth quarter, which set an artificially high bar for net income numbers in subsequent quarters.
Overall, we are optimistic about the third quarter net income figures given the strong rise in the Libor over the past few months. Non-bookings across the sector are also holding up and BDCs are taking advantage of better prices to grow their portfolios. We expect these tailwinds to keep net earnings up on average over the next quarter.
Second-quarter earnings continued to dominate news flow in the industry. In this weekly commentary, we’ll only highlight a handful of the criticisms we normally make about the service.
The net asset value of Oaktree Specialty Lending Corp. (OCSL) fell 5%. The company has tended to be quite conservative with its brands compared to the wider industry. We saw the same behavior in 2020, where its net asset value fell far more than the industry average, but then rebounded as spreads tightened.
Non-bookings remained nil and gains were made in the quarter. Leverage increased, although this was mainly due to falling valuations as net investments remained stable. The dividend has been increased by half a cent, so the yield is now 9.6%. Dividend coverage is 100%, but should increase as short-term rates continue to filter through. The company has also raised its debt target, which will give it more capacity to develop its assets.
OCSL’s valuation at 103% is a bit pricey compared to where it is traded, but we have to keep in mind that if we were doing an apples-to-apples NAV valuation, it wouldn’t see probably only a 2-3% decline in net asset value from its actual value. 5% drop.
This means that its valuation is closer to 100% which is in the fair value camp. The stock remains in the Basic Income and High Income portfolios. It has outperformed the BDC sector since the beginning of the year by about 3% and is stable over the year.
Fidus Investment Net Asset Value (FDUS) fell half a percent while GAAP income increased (adjusted was stable). The company has mostly fixed rate liabilities, so its income beta to a higher Libor is quite high. The company also continues to transition to a higher Tier 1 allocation which has increased every quarter for the past few years. This rotation will be a tailwind to net earnings in the coming quarters.
Defaults have gone from 0.3% at fair value to 1% (and from zero at the end of the year) and deserve to be monitored. Leverage remains quite low at 0.8x. FDUS is trading at a yield of 10.6% with a valuation of 101%. We have held the stocks in our high income portfolio since last year – they have increased by 17% in terms of total return in 2022.
Location and takeaways
Continued strength in the labor market means that, despite the market consensus, the Fed is highly unlikely to adopt a more dovish stance soon. We remain of the view that investors should have allocations in their portfolios that can take advantage of short-term rates that could very well exceed market expectations and stay there longer than expected. Historically resilient BDCs can perform this function very well in diversified income portfolios. After increasing our holdings in BDC on the downside, we did not continue the recent rally. In fact, we downgraded our OCSL position from To buy at Hold thanks to its 14% rebound from the recent low. The market is expected to remain volatile, which may provide income-oriented investors with better entry points for additional BDC allocations this year.