Trinity Capital: What To Look Out For In This 14% Yielders Earnings (NASDAQ:TRIN)

Trinity Capital (NASDAQ:TRIN) is an internally managed BDC currently offering a highly attractive dividend yield of around 14%. The BDC has performed excellently so far in 2023 and is set to report its fourth quarter earnings on the 29th of February. I will be looking at certain key points in its upcoming earnings report, including aspects of its portfolio and the sustainability of the dividend.

The broader BDC sector is bracing for a more challenging landscape in 2024 amidst declining interest rates and mounting credit quality concerns. Recent commentary from industry analysts, including insights from Fitch, underscores expectations of weakness in cyclicals amid economic softening. This potential turn in the current credit cycle makes it important to closely monitor TRIN’s portfolio and the movement across risk ratings. The potential decline in interest rates also makes it important to understand the extent to which the dividend would remain covered by NII, even in a declining interest rate environment.

The portfolio

The BDC sector is expected to witness a more challenging time-period in 2024 as interest rates start to decline, and early indications suggests an increase in credit quality issues across the sector. Fitch recently observed that –

Recent commentary from BDC executives indicates expected weakness in cyclicals as the economy softens, although Fitch recently removed its forecast of a recession in 2024. Companies with scale may be better positioned to withstand the deteriorating operating environment, given the larger EBITDA basis and better flexibility to offset higher costs on floating-rate loans. BDCs are beginning to see an uptick in credit issues, with around 9% of portfolios, on average, consisting of restructured assets, non-accruals and loans marked below 90% of par, up from around 7% at YE 2021, according to Wells Fargo.”

These early signs of a deterioration in asset quality has also been present at TRIN, which in the third-quarter reported its second consecutive increase in the percentage of its portfolio placed on the watch list. Trinity Capital employs a comprehensive investment risk rating system, evaluating seven distinct criteria. Based on this assessment, the BDC assigns a risk rating ranging from 1 to 5. The criteria under consideration encompass various aspects such as liquidity/cash life, performance against projections, collateral coverage, and product differentiation, among others. Investments rated between 4.0 – 5.0 are the best performing, while those rated at 1.0 – 1.5 are in default or being renegotiated.

As can be seen in the chart above, the majority of TRIN’s portfolio is classified as performing in the 2.0 – 2.9 risk rating area. However, the percentage of its portfolio rated above performing has been steadily declining as more of the portfolio companies that previously outperformed are merely moved to performing. While this does not represent a challenge as long as these underlying portfolio companies continue to meet their debt obligations, it does signal that an increasing number of portfolio companies that previously outperformed expectations are no longer doing so.

In my view, the percentage of its portfolio placed on the watch list is likely to have increased again in the fourth quarter. It will be important to monitor the precise extent of this increase, as these risk ratings provide investors with early indicators of potential challenges in the portfolio. However, TRIN has proven itself to be an adept manager, and it seems unlikely that non-accruals will rise to an unsustainable level.

The dividend and net investment income

TRIN currently offers a dividend yield of around 14% which is higher than that offered by most of its large-BDC peers. TRIN has also increased its dividend quite significantly in the course of the past few years, with the regular quarterly dividend having increased from $0.28 per share in March 2021 to the third quarter dividend of $0.5 per share. In my view, the dividend growth witnessed so far is likely to slow down substantially in the near term as the sector grapples with a new operating environment in which interest rates are declining.

Nevertheless, the current dividend is well-covered by net investment income (NII). TRIN also has a one-year average NII coverage ratio of almost 120% which, although the second lowest of the major BDCs included in the peer comp chart below, positions it well to continue paying the current dividend. I expect the dividend to be well covered by Q4 earnings as well, and don’t see dividend coverage at TRIN as an area for concern at this point in time.

In the third quarter, TRIN had a strong origination quarter which, in turn, contributed to a substantial increase in NII. It seems likely that the fourth quarter may have presented an even greater opportunity for new originations, as several other BDCs like Ares Capital (ARCC) already reported substantial increases in their origination within the fourth quarter. This increase in originations seems to be driven in part by an increasingly positive interest rate outlook among borrowers, i.e. borrowers are less concerned about rising interest rates than they were earlier in the year.

Valuation

TRIN is currently trading at a premium to NAV of just under 10%. This is the second highest of the major BDCs considered in the peer comp chart below, and slightly above its 3-year average premium to NAV of just under 5%. In my view, this premium-to-NAV is likely part of a broader rerating of the stock in light of its continued NAV growth and excellent dividend increases.

In my view, the stock is not accordingly overvalued despite being priced above its 3-year average price-to-NAV. Nevertheless, the stock price could experience some volatility related to uncertainty over the future of interest rates and their potential impact on NII.

Conclusion

As Trinity Capital prepares to report its fourth-quarter earnings, attention will be particularly focused on the sustainability of its dividend and the resilience of its portfolio. The broader BDC sector anticipates a challenging landscape in 2024, marked by declining interest rates and escalating credit quality concerns. Early signs of asset quality deterioration have surfaced at TRIN, prompting a closer examination of its portfolio movements and risk ratings. Nevertheless, while the percentage of the portfolio placed on the watch list may have increased, TRIN’s adept management suggests a manageable trajectory for non-accruals.

TRIN’s dividend also continues to be well-covered by NII, leaving it with scope to maintain the dividend even interest rate cuts were to bring about a decline in NII. Although dividend growth may decelerate amidst changing interest rate dynamics, TRIN’s historical performance instils confidence in its ability to sustain dividends. Furthermore, a lower interest rate environment may bring about new origination opportunities that could again be accretive to NII.