BDC Weekly Review: BDCs Rush To Issue Bonds

Welcome to another installment of our BDC Market Weekly Review, where we discuss market activity in the Business Development Company (“BDC”) sector from both the bottom-up – highlighting individual news and events – as well as the top-down – providing an overview of the broader market.

We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the third week of January.

Market Action

BDCs were down around 1% on the week, led by the venture-backed, higher-beta BDCs like HRZN, HTGC, TRIN and TPVG. Month-to-date, the sector is still sitting on substantial gains despite an unwinding of some expectations of Fed’s rate cuts.

Aggregate valuations remain elevated, trading slightly above their historic average. A high level of short-term rates, an inverted yield curve and a likely delayed start to Fed’s cuts continue to support the sector.

Market Themes

One interesting trend we have seen so far at the start of the year is the rush on the part of BDCs (as well as other investment companies) to issue bonds. So far we have seen the following new issues cross our screen:

• ARCC 5.875% 2029 bond
• TSLX 6.125% 2029 bond
• MAIN 6.95% 2029 bond

This may not seem like much however it is much more than we saw towards the end of the year. Clearly, the drop in yields has been the key catalyst for this trend. An opening up of bond markets in the new year as well as very tight credit spreads are other factors assisting new issuance.

However, long-term yields are still relatively high even though they have fallen significantly. This raises the obvious question – why don’t BDCs wait for even lower rates given inflation is expected to keep falling over time?

As we touched on in a recent Preferreds Weekly, further disinflation is already priced in by markets so rates will not necessarily fall if inflation continues to drop – they will fall if disinflation proves stronger than what is priced in.

Two, BDC leverage has decreased in aggregate in the last several quarters. In this sense, BDCs have already been very patient by reducing their portfolios and, therefore, reliance on financing. However, ultimately, there is a limit to this patience and BDCs need to generate net income if they don’t want to cut dividends. The recent drop in yields is precisely what many BDCs have been waiting for. With the average BDC generating around 13% on its portfolio, paying away 6-7% in financing is not a bad deal.

Three, it may seem counterintuitive but today’s investment environment is actually better for BDCs than it was in 2021 when rates were at rock bottom levels. Ultimately, what matters to BDCs is not the level of rates but the shape of the yield curve and credit spreads.

Today’s yield curve is extremely inverted and, hence, extremely positive for BDCs which mostly lend short and borrow short and long (the average BDC has around half of its financing at short-term rates and half in longer-term rates). By issuing a bond, BDCs are generating around 2.5% more in net income than they have historically.

The key risk for BDCs is that short-term rates fall significantly, leaving them with high locked-in rates on their debt. That said, neither markets nor the Fed expect this to happen very soon. And even if it does, the amount of recent bond issuance is small.

Something else to keep in mind is that recent issuance will cause net income to step marginally lower as it is replacing lower-coupon bonds in most cases.

Market Commentary

Golub Capital BDC (GBDC) raised the dividend to $0.39 from $0.37. The company also waived incentive fees above 15% from the previous 20%. The change will be permanent after the merger.

The drop in the incentive fee makes GBDC’s fee structure the best across the BDCs we cover. Previously, BXSL and PFLT gave GBDC a run for its money however they now have higher incentive fees and the same base management fee.

Clearly the drop in incentive fees is one of the catalysts for the dividend hike, however, given the wide gap between net income and the base dividend as the chart below shows, it’s clear that with coverage of 135%, the hike is not a big surprise.

The company estimates calendar Q4 net income to be $0.49 or slightly below the previous quarter. That pushes coverage down to a still very high 126%.

We continue to have a position in the company in our Income Portfolios, however, it has been downsized now that its valuation has recovered to near parity with the sector. A drop towards a 5% discount vs. the sector would make it attractive for new allocation.

Stance And Takeaways

BDCs have held up well so far despite expectations of near imminent Fed rate cuts. The recent taming of those expectations in light of strong macro numbers and decent corporate profits have further supported the sector. The key test for the sector is whether borrowers will be able to move over the rate hump without significant defaults. Any significant pause in the Fed policy rate is likely to keep piling on pressure on BDC borrowers.