BDC Weekly: Several factors explain the resilience of net asset value in the second quarter

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Darren415

This article was first published to Systematic Income subscribers and free trials on August 13.

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 August.

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

It was a great week for the BDC sector with a total return of 3% as all but two stocks rallied with the two laggards falling on public offerings. The recovery in the income space accelerated this week thanks to benign inflation indicators as well as a rebound in consumer confidence. Good earnings releases, dividend increases and rising short-term rates also supported the sector.

All of this leaves the BDC sector fairly stable for the year, which is quite an extraordinary achievement in the context of all that has happened. In contrast, high yield corporate bond CEFs are down 13% and loan CEFs are down 9% year-to-date.

Systematic income

Systematic income

With most of BDC’s earnings, the average decline in net asset value in the second quarter was just under 3%.

Systematic income

Systematic income

The total net asset value return, however, was only marginally in the red, with dividends nearly matching the decline in net asset values.

Systematic income

Systematic income

BDC’s average valuation has increased to 103%, which is in line with the historical median level (green line) and slightly above the historical average (red line). Given the very likely downward trend in corporate earnings and a very significant continued compression of interest coverage in the sector, this now seems a bit costly to us.

Systematic income

Systematic income

Market themes

Compared to other income sectors, BDC net asset values ​​were very resilient in the second quarter. The median decline in BDC’s net asset value in the second quarter was just 2.1%, with the average of around 2.7% driven primarily by an ongoing value trap that is FCRD.

Systematic income

Systematic income

In the context of this performance, only Munis recorded a higher figure in the second quarter.

Systematic income

Systematic income

Given that BDCs are highly leveraged (significantly higher than even credit CEFs) and hold allocations to companies that themselves operate at high leverage, what explains this resilient performance of the ANR in the second quarter?

The first-order explanation is quite simple – BDC’s net asset values ​​aren’t really marked-to-market unlike the assets of all the other sectors in the chart above. BDC’s holdings are valued quarterly using market data and third-party valuation specialists and auditors. However, they are not susceptible to the same kinds of liquidity considerations as other publicly traded assets. It is no coincidence that BDC prices tend to fall much more than NAVs during drawdowns. For example, BDC’s average price fell about 45% in the second quarter of 2020, while the average net asset value fell only 10%. In short, it’s fair to conclude that the market doesn’t really believe that in the event of a sharp drop, BDC’s net asset values ​​are really and truly that resilient.

Overall, there is nothing inappropriate about this dynamic and, in fact, it gives BDCs a sort of superpower, much like that enjoyed by private equity. It allows BDCs to maintain a very high level of indebtedness while holding very illiquid assets. Lending CEFs tend to be much less leveraged, largely due to the increased risk of deleveraging. For example, NAVs for CEF loans fell in the range of 30% in the second quarter of 2020 – a drop that caused many funds to deleverage. Obviously, few people really believe that BDC assets are somehow more than 3x more resilient, even though their returns tend to be higher than those offered by exchange-traded loans.

There are a number of other second-order factors for NAV resilience at T2. One is the fact that many BDCs perform NAV accretive market actions such as ATM public offerings/issues (if the stock is trading at a premium like CSWC or MAIN) or share buybacks ( if the stock is trading at a discount like CGBD). This can add up to 1-2% to the net asset value per quarter. Second, BDCs can show significant gains on their equity/warrant positions, which distinguishes them from loan CEFs. Third, the recent upward trend in rates has helped raise net income above the current dividend level that goes directly to NAV (at least temporarily, as the BDC can often increase the base dividend and/or or pay a special/additional dividend) . Fourth, BDCs can generate significant windfall fee income due to prepayments. Admittedly, this source of income was relatively subdued in Q2.

Different BDCs have different profiles when it comes to these additional performance drivers, but most BDCs feature at least some of them. This does not mean that BDCs are impervious to large permanent losses, but they can provide a tailwind to net asset value during periods of volatility.

Market Commentary

This week, we highlight a subset of BDC’s earnings that we continue to report on at Systematic Income.

The Blackstone Secured Lending Fund (BXSL) published good results in the second quarter. Net asset value was down 1%, although most of it was due to the special dividend. The base dividend coverage is 117%, suggesting that the base dividend should start increasing at some point.

BDC Systematic Income Tool

BDC Systematic Income Tool

Leverage has increased and is overall quite high at 1.3x. Non-counts remain at zero although PIK revenue has increased. We bought BXSL in our Basic Income and High Income portfolio in the second week of July when it was trading around $23. At $25.20, it’s far less attractive, though we expect its 97% valuation to approach the industry average over time.

The net asset value of Golub Capital (GBDC) fell 1.4%, with the total net asset value return in the second quarter of +0.6%, around 1% better than the sector. Adjusted net earnings went from $0.3 to $0.31 against a dividend of $0.30. Net new investments were positive and leverage increased. This, combined with a high beta to rising short-term rates, should keep net profit up in the coming quarters. Defaults remained stable, as did the internal portfolio quality rating. GBDC has tended to be a low-octane BDC due to its large top-tier allocation and low-return asset profile, but it has outperformed the sector over the past two quarters.

BDC Systematic Income Tool

BDC Systematic Income Tool

At a valuation of 94%, it looks quite attractive compared to the industry average of 103%, especially given its lower fee structure. This is a good position to balance some of the higher capital BDCs like FDUS or ARCC in BDC portfolios. GBDC remains in our Basic Income and High Income portfolios.

Position and takeaways

Our BDC portfolio in the high income portfolio has generated a total return of just over 10% since the start of the year, outperforming the sector as a whole, as shown in the following chart.

Systematic income

Systematic income

This performance is due to three main factors. First, our main overweights were TCPC (since they shifted to other BDCs), FDUS and CGBD, all of which posted double-digit total returns year-to-date. Second, we added to our exposure to BDC during the decline, particularly in TRIN and BXSL, replacing shorter dated assets like BDC bonds and mREIT which held up very well. And third, we have made timely rotations between BDCs, as their valuations have turned sharply this year.

Given that we were able to increase our holdings in BDC through the drawdown, the bar for additional purchases is quite high at the moment, especially at current levels which are well above our entry levels. That said, for investors who find they are still underweight BDC, we continue to like BXSL and GBDC here due to their below average valuation and higher quality allocation profile.

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