BDC Weekly Update: Second quarter unlucky with credit spreads
This article was first published to Systematic Income subscribers and free trials on July 23.
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 – 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 third week of July.
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.
It was a great week for the BDC sector with an average gain of around 2.5%. Only two BDCs – BXSL and FCRD – fell, although BXSL fell only slightly. In July, the sector is up around 4.5%.
A look at year-to-date performance tells us that the underperformers this year form a sort of dumbbell – strong historical performers whose valuation in 2021 has exceeded their ability to generate value (TPVG, CSWC , HRZN) as well as low performing value traps (FCRD, MRCC). BXSL is arguably a special case that has been pressured by blocking exhalations.
The graph below shows that BXSL volume is correlated with the occurrence of lockout expiries. Volume has been declining recently, suggesting that the supply and demand picture is relatively clean for the stock going forward.
The sector has continued to pull itself out of its hole and is about a third of the way from this year’s pullback low. However, we do not expect a full recovery any time soon as net asset values are expected to decline and valuations are expected to remain subdued due to expectations of corporate margin compression, rising costs, softer aggregate demand and an increase in non-regularizations.
The sector’s valuation remains below its longer-term average. Part of this valuation gap will be filled by the very likely drop in NAVs in Q2.
Investors are eagerly anticipating Q2 earnings from the BDC sector. A key metric that investors look forward to is the change in book value or net asset value of individual BDCs as well as the trend across the industry.
In addition to portfolio quality, non-accruals, income variations and the like, a key driver of net asset value is the broader valuation of loan assets, in particular, as seen in the publicly traded market. We know this is a key driver of NAV because management itself alludes to it when discussing NAV.
A very interesting trend in the traded market is that while high yield corporate bond credit spreads in the first quarter were very well contained, they widened significantly in the second quarter. Specifically, the first quarter saw the spreads increase from 3.1% to 3.43%, while the second quarter saw the spreads increase from 3.43% to 5.87%.
If we look at the chart below marking Q2 boundaries, we can see that Q1 was quite fortunate with spreads retracing much of their earlier widening shortly before the end of Q1. Meanwhile, Q2 was unlucky on both ends – as spreads were momentarily tight at the end of Q1 and very wide at the end of Q2. Specifically, credit spreads have fallen 1% since the end of the second quarter.
What this suggests is that Q2 NAVs and NAV changes are likely to be “worse than they are” as they reflect this bad luck at both ends of the quarter. Compared to today’s credit spreads, Q2 NAVs will be slightly lower than if marked to market today due to the large rally in credit since the end of the quarter. Similarly, today’s “marked-to-market” valuations (i.e. price/NAV ratios) are also slightly lower than those based on Q2 figures (as market-to-market valuations are expected to be higher). Investors should consider this timing impact if targeting valuations within their entry/exit levels.
BDC Trinity Capital (TRIN) is issuing an additional $50 million of its 7% 2025 bonds at a little below par. Apparently it’s to pay off their KeyBank credit facility. The timing and decision to forfeit a credit facility is a bit odd.
First, the company’s credit facility exposure is already low in the industry relative to its outstanding bonds at around 26% in the first quarter and that will obviously decline further. In other words, the proportion of bonds in TRIN’s capital structure is already high by industry standards and will increase further.
Second, the bond carries a higher interest rate. TRIN is paying 1M Libor + 2.85-3.25% on the credit facility against just over 7% yield on tap. The 1M Libor is currently hovering around 2.2% but will likely peak around 3.5% if the Fed Funds consensus forecast is correct. That would leave the credit facility still cheaper than the Fed Funds likely peak bond, but not by much.
Interestingly, the bond was originally issued in early 2020, so the company, in effect, completely missed the opportunity to lock in a low level of interest by doing nothing between the second quarter of 2020 and the end of 2021. Many other BDCs canceled their obligations in 2021 when it was advantageous to do so.
A potential saving grace is that the bond is callable (without compensation) at the beginning of 2023. However, it seems unlikely that we will get significantly lower yields from now (which would make it economical to refinance the bond) because this would require both lower Treasury yields as well as credit spreads. This Goldilocks scenario would require both inflation to start falling earlier than expected and recession to be averted – a big ask.
An important factor to keep in mind is that in a flat yield curve environment, credit facilities do not offer as much savings on interest charges over bonds as they would in a curve environment. of “normal” yield, i.e. on an upward slope. TRIN can simply look at the balance of the additional covenants on the credit facility and compare it to a slightly lower interest charge and judge that it would prefer to pay a slightly higher interest rate without having to worry about the additional covenants, especially at a time when the economy could enter a recession.
There was a question about CION Investment Corp. (CION) on the service given its significant discount. The first thing to mention is that it is difficult to have much belief in the CION team because their track record is not very clear. They were under-advised by Apollo for a while, then they bought a CS BDC. Hard to know what value the CION team itself adds or subtracts.
Second, their net asset value is around 3% below their 2019 level, while most BDCs are above their 2019 levels, suggesting some weakness going through the COVID period and if this is true , they could also fight against the coming recession. Their 3-year total net asset value return (very approximate as it doesn’t include compounding) appears to be in the range of about 4%, which is less than half of the BDC sector, so the performance here is not surprising. If that’s correct, the discount isn’t big enough at current levels.
Position and takeaways
After increasing our allocation lower, we did not continue the recent BDC rally for several reasons. First, we expect the upcoming earnings season, and in particular the very likely NAV declines, to lead to additional volatility. And second, we expect a marginal deterioration in portfolio quality and an increase in non-accruals due to a slowdown in aggregate demand and pressure on corporate margins. Based on Q1 management comments, a good portion of BDC’s portfolio companies will see their interest coverage fall below 1x in the coming months, making it more difficult to service debt.
That said, for investors who have been on the sidelines for most of the year, we like the Golub BDC (GBDC) which trades at an 8.73% dividend yield and a 90% valuation on Q1 NAV, as well as Oaktree Specialty Lending Corp (OCSL) trading at a 9.7% dividend yield and a 94% valuation on Q1 NAV. These BDCs offer higher quality/less equity portfolios that we believe will be more resilient over the medium term.