This was a hard week to be a BDC common stock investor.
After several weeks of ups and downs in a narrow range, BDC prices mostly moved clearly to the downside.
We’ll start as we most always do with the UBS Exchange Traded Note with the ticker BDCS, which fell to $20.361 from $20.72 the week before, a (1.7% drop).
BDCS was at $20.90 a fortnight ago, so the two week decline is (2.6%).
Likewise, the Wells Fargo BDC Index dropped (1.4%) in a week and (2.4%) over two weeks.
Much of the rest of the data lined up to suggest that the BDC rally of these past many months is drawing its last breaths.
Let us count the ways:
Most telling, only 7 BDCs out of 45 tracked closed the week at a price above their 50 Day Moving Average.
That’s a massive downshift from 20 last week and 34 back on August 10, 2018.
Less dramatic – but still noted – is that 30 BDCs continue to trade over their 200 Day Moving Average.
That’s down from 32 last week and 36 as recently as the end of August.
Also noteworthy is that the number of BDCs trading within 5% of their 52 Week High dropped to 7 from 14 the week before.
This has been a very consistent category with the number of BDCs close to their tops oscillating between 13-15 for several weeks.
Moreover, the number of BDCs now trading above book value has come down from 14 a few weeks ago, to 12 in our last report and now 10.
Just to put the cherry on the cake, 6 BDCs dropped 3% or more in price, while only 2 increased by 3% or more.
So all the writing is on the wall thanks to a major shift in market sentiment brought on by higher long term rates.
Not to mention “hawkish” comments from the Fed about the future path of the Fed Funds rate.
As many readers will know better than us all the main indices dropped at the prospect of paying more for capital, and BDCS was no exception.
Of course, a contrarian argument can be made that the recent increase in the Fed Funds rate and in LIBOR will boost short term earnings prospects at many BDCs.
In fact, an article on October 4, 2018 at LevFin Insights argued these are good conditions for leveraged loan investors.
Moreover, the strong economy that has caused this boost in rates is almost a guarantee that the biggest threat to leveraged lenders – credit losses – will remain muted.
Sentiment surveys of lenders predict (for what it’s worth) that loan losses in 2018 and 2019 for larger transactions will remain way, way below historical averages.
Here’s an extract from LevFin which speaks to the subject:
“Fitch Ratings forecasts the loan market default rate will drop to 1.5% by yearend 2019 from the latest reading of 2.2% in September ”.
Even companies that are going into bankruptcy (yes Virginia there are a few) are coming out very quickly with restructured balance sheets and high hopes.
For example, American Tire Distributors filed for Chapter 11 on Thursday had negotiated a bankruptcy-exiting agreement in principle with its senior lenders by Friday !
The company is expected to be out of court protection by year end.
None of that mattered this week.
Sentiment shifted to the worry stage as happens, and everything that was previously right as rain became a potential problem.
Here’s just one example amongst many in the credit space.
On October 4, 2018 the Wall Street Journal reported that junk bond investors are:
…getting antsy about the junk-bond market.
They pulled money out of the biggest exchange-traded fund that bets on high-yield credit during September at the fastest pace in almost 2½ years.
All Done Here ?
So the credit rally is over,and the BDC sector is going to head down, down, down ? Right ?
Not so fast – says the BDC Reporter- which may be kicking itself this time next week for saying so.
We know and respect the expression “don’t fight the tape” (even though we doubt many of us have actually seen stock ticker tapes).
However, we’re not yet convinced that this current malaise will last all that much longer, bringing down BDC prices to correction or bear market levels.
We can’t speak to general market sentiment which – as they say – is “going to do what it’s going to do”.
Our Humble Contribution
On the other hand, with our wall to wall coverage of the 45 public BDCs, we have some insights into BDC sector fundamentals.
We may wring our hands about what higher leverage allowed by the Small Business Credit Availability Act (SBCAA) might do to credit losses and earnings in 2020 and beyond.
Pretty, Pretty Good
However, that will be then and this is now, where a confluence of factors is making for relatively safe sailing in BDC waters.
Thankfully most of the BDCs that encountered credit troubles in recent years have begun – and largely completed – their portfolio turnarounds.
We’re thinking of Apollo Investment (AINV), Alcentra Capital (ABDC), Capitala Finance (CPTA), Gladstone Capital(GLAD),THL Credit (TCRD), CM Finance (CMFN) and Garrison Capital (GARS).
Triangle Capital solved its mounting credit problems by the sale of its entire portfolio to a non-traded BDC, and under a new name (Barings BDC) and leadership is sitting on a small mountain of cash.
Medley Capital (MCC) – for better or worse – has found a way out of its credit mess by merging with two sister companies.
How that will end nobody knows (but we have our suspicions) but in the short term the stock price is supported.
In fact, one of the two BDCs moving up more than 3% this week was MCC, up 3.1%.
The other was Harvest Capital (HCAP), another BDC with prior credit troubles and a reduced dividend in the rear mirror.
Or so the market seems to believe.
Great Elm Corporation (GECC) – after years of absorbing restructurings and write-downs of its largest portfolio company Avanti Communications actually had good news about the company’s performance of late.
Again, we cannot speak for the longer term outlook, but for the short term this has relieved some of the pressure on the former Full Circle Financial.
Also encouraging is that the high performers of the BDC sector such as Ares Capital (ARCC), TPG Specialty (TSLX), Golub Capital (GBDC), BlackRock TCP Capital (TCPC) and Main Street (MAIN- to name but a few of the top names – have all been meeting or exceeding expectations, notwithstanding murderously competitive market conditions.
ARCC increased its regular distribution this year after paying the same quarterly dividend of $0.38 since September 2012.
MAIN – once again – increased its regular distribution.
Both BDCs are generally expected to do so again in 2019.
Plus, some of the up and coming smaller BDCs have been recording excellent results including ambitious newcomer Capital Southwest (CSWC)- which just raised more equity at a premium to book last week and veterans like Gladstone Investment (GAIN), benefiting from the middle market M&A boom; and Newtek Business (NEWT) has been going from strength to strength; regularly raising its annual pay-out.
As a result, earnings and dividend expectations across the sector – with only a few exceptions – are very stable in the short and medium term.
Till the SBCAA came along we’ve been predicting – with some success – the outlook for BDC distributions over a 12 month time horizon.
When the SBCAA and all its uncertainties came along, we’ve put away our crystal ball.
However, before we gave up, we had identified only two BDCs likely to reduce their distributions and 7 likely to increase. (8 if you include the Barings BDC -BBDC – whose pay-out will be shooting up with every quarter).
It Could Happen
As we reviewed the BDC universe one more time for this recap we can envisage – thanks to the SBCA, higher LIBOR rates and the timing of individual BDC recoveries – that no BDC might reduce its distribution in the next 12 months.
With numerous BDCs poised to increase their dividends, aggregate BDC distributions may grow up to 5% or more in 2019 over the current level.
Of course, the market knows all this, which probably is the cause for the 7 month rally.
Our Key Assumption
We question, though, whether BDC investors will walk away at this juncture with this relatively cloud free horizon ahead just because of a fear of higher interest rates, or tariffs or whatever the “real” cause of this week’s market melt-down may be ultimately associated with.
Markets may look ahead, but we doubt that they are looking to what may or may not happen in 2020 or beyond.
The BDC sector has not yet dropped 5% from its most recent high. That’s the arbitrary number we’ve adopted after a decade of tracking BDC ups and downs.
As of Friday October 4, 2018, the BDC sector was (3.2%) off its high.
We remain optimistic – notwithstanding what our data and the trends in the ticker tape – that we will not drop much further.
Our principal caveat is that all all predictions are off if the broader markets get in the grips of those occasional panics with which we are only too familiar.
Check back with us next week (and in the weeks to come) to determine if we are “hero or goat” where BDC market calling is concerned.