This article was first published to Systematic Income subscribers and free trials on January 22.
Welcome to another installment of our weekly BDC Market Review where we discuss market activity in the business development companies sector both bottom-up – highlighting individual news and events – as well as top to bottom – offering a broader market overview.
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 third week of January.
Be sure to check out our other weeklies – covering the CEF as well as the 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.
The BDC sector, along with most other risky assets, was down this week, with only one stock managing to stay in the green among those we track. As of the beginning of the year, about a third of this universe is still active.
On a monthly basis, January is shaping up to be the worst month since October 2020 and the second worst month since March 2020.
Overall, BDCs have remained somewhat resilient year-to-date amid the current decline, despite their reputation as a higher-beta sector.
What is interesting about the sector’s behavior is how it has reacted to changes in Treasury yields. Treasury yields more or less rose in a straight line from the start of the year until January 18, when they began to decline.
During the period when treasury yields rose, the BDC sector performed exceptionally well, up 2% – one of only 3 income sectors to post positive returns.
However, in the period since Jan. 18, when Treasury yields have fallen, BDCs have underperformed, adopting their usual higher-beta profile in a weak market.
Why did BDCs provide such disparate performance in the two market regimes? In our view, this has to do with the fact that a more hawkish Fed stance means a faster upside trajectory which, in turn, means the sector will deliver higher levels of income much faster.
The market consensus has recently changed wait 4, rather than 3 hikes this year. And some colorful personalities, such as Jamie Dimon, even suggest we could see something like 6-7 hikes this year. More and faster increases mean that the sector will move through the drop in net investment income more quickly.
The chart below shows the NII profile for different levels of Libor for the Goldman Sachs BDC (GSBD) which is fairly typical for the industry. The NII drops to a level of around 1% in the Libor (equivalent to around 4 rises) and rises sharply thereafter.
This has to do with the fact that BDCs hold loans with Libor floors of around 0.5% to 1%, which means that the active side of their balance sheet will not generate an appreciable increase in the NII from the first rises. , but the liability side of the balance sheet will become more expensive due to the presence of uncapped floating rate credit facilities. It is only when the Libor rises north of 0.75% to 1% that BDCs, as a whole, will generate higher levels of income compared to today, all other things being equal. This dynamic is not true for all BDCs since some have exclusively fixed rate liabilities, but it is true for most.
In our view, the strength of the BDC sector through January 18 – a period that appeared to be driven by an expectation of higher policy rates – means it can remain attractive in a rising rate environment, particularly if the focus remains on the short-term -end-tariffs.
However, investors should also remember that during “normal” drawdowns, when risky assets fall and Treasury yields fall, BDCs can also underperform. In our opinion, the conclusion is quite positive for BDC investors. No one expects BDCs to outperform on a traditional decline – something that was made very clear in March 2020. However, in a weak market environment where weakness is driven by interest rate concerns higher managers, BDCs can deliver superior outperformance than we can say for most income sectors.
Besides the market weakness this week, it was a fairly quiet week in the sector as the market geared up for the fourth quarter reports.
WhiteHorse Finance (WHF) and Fidus Investment (FDUS) remain at valuations below 100%, which is reasonably, if not impressively, attractive. Check out our article archive for recent updates on both companies. Both companies continue to trade at lower valuations than the industry despite consistently outperforming NAV returns over the past 5 years.
One thing is worth nothing is that these valuations are based on the Q3 NAVs, so if the Q4 NAVs go down, these valuations are overvalued, i.e. too low and, therefore, wrongly attractive . That said, year-end credit spreads were very tight, so we don’t expect large negative declines in net asset value, suggesting that current valuations are a fair representation of fourth quarter net asset values.