BDC Sector Market Review: BDC or CEF Lending for Higher Rates?
This article was first published to Systematic Income subscribers and free trials on January 29.
Welcome to another installment of our weekly BDC Market Review where we discuss market activity in the business development companies sector both bottom-up – highlighting individual news and events – as well as top to bottom – offering a broader market overview.
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 fourth week of January.
Be sure to check out our other weeklies – covering CEF as well as 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 another tough week for the broader earnings space, with most sectors ending in the red. BDCs made a small positive return, showing an ability to outperform in a weaker and more hawkish market environment. The largest BDCs have tended to outperform since the start of the year with ARCC, FSK and ORCC – the three largest ex-BXSL BDCs, which are under some technical pressure, posting positive returns.
Overall, this recent decline has been quite supportive for BDCs – largely due to higher short-term rates, as we explain in the Themes section below. This week, Goldman Sachs moved its Fed policy forecast from 4 to 5 hikes, with 5 hikes now becoming the market consensus.
An interesting trend that has also emerged in sector returns is that higher-valued BDCs have outperformed their lower-valued counterparts. This type of procyclical behavior (outperformance during rallies / underperformance during periods of weakness) is familiar to BDC and CEF investors. This more defensive market characteristic of low-valued BDCs during downturns can be attractive to investors who want to manage volatility in their portfolios.
Short-term yields continue to climb – since the start of the year, the 2-year Treasury yield has risen from 0.73% to 1.15% or 0.42% while the 30-year has only risen than 0.06%. The market is basically saying that year to date it now expects two more hikes in the next two years, but the longer term end point of Fed policy is about the same only at the end of the year.
Last week we highlighted an interesting BDC theme in the context of the broader income market. This theme was the BDC’s tendency to be more resilient during short-term rate hike days.
Recall that short-term rates move largely in anticipation of changes to the Fed’s key rate, which has been anchored around zero since the COVID crash of 2020. Recently, short-term rates have been particularly volatile, not only due to sustained inflation, but also new variant developments and their impact on the labor market as well as the Fed’s shift in a more hawkish direction.
If we look at how BDCs have performed against stocks (using the S&P 500 ETF as a proxy) since the start of the year, we get the chart below which is not immediately insightful and simply shows that the BDC and SPY are quite volatile and sort of all in place.
However, as we highlighted in our last week, BDCs have tended to outperform the broader market and bounce off higher short-term rates. The chart below breaks down BDC’s performance against SPY by days when the 2-year Treasury yield rose (9 days this month) and when it fell (7 days this month).
This chart clearly shows that while equities weren’t particularly sensitive to the direction of short-term rates, BDCs clearly liked days when short-term rates rose. Using median price returns produces roughly the same chart, so this effect is not due to a single abnormal day.
As we discussed last week, this seems to be a direct result of the expectation of a higher NII in the BDC space later this year once the Fed breaks through 3-4 hikes and more. The Fed will get there the faster the BDC market will be. the overall income will increase.
This all makes sense, however, BDCs are not the only income product that offers exposure to floating rate assets. Lending CEFs are quite similar – they also hold loans (except that CEFs tend to hold exchange-traded loans while BDCs hold privately originated loans) and they are also leveraged ( although at a slightly lower level than BDCs).
If we include Lending CEFs (as approximated by the 6 Largest Lending CEFs) in the chart above, we get the following picture. Lending CEFs have a similar pattern to BDCs, perhaps surprisingly more downside volatile on days when yields decline.
Overall, however, BDCs are expected to generate a higher level of income than lending CEFs for two main reasons. First, BDCs operate with higher leverage. And, more importantly, BDCs have a higher level of fixed rate leverage (60% on average by our calculations) whereas almost all CEF leveraged loan facilities are floating rate. Expected changes in income levels are not the only factor in the allocation between these two investment vehicles, but it is an important factor to consider.
Position and takeaways
An important feature of today’s market is that credit has so far held up quite well relative to equities, as the following chart of monthly returns shows.
This means that we have much more faith in credit-oriented BDC valuations (i.e. those with a small allocation to equities/warrants). In other words, a heavily equity-focused BDC might look very attractive right now on valuation grounds; however, this valuation is most likely overstated given the recent weakness in equities. Q4 net asset values for equity-heavy BDCs are expected to be quite strong as equities rallied in the last quarter of 2021. However, if equities remain weak, Q1 numbers could prove disappointing .
We have 6 BDC allocations in our high income portfolio; however, to finish, we will highlight the BlackRock TCP Capital Corp. (TCPC), discussed earlier here, and the TCG BDC (CGBD), discussed here, both of which trade at attractive valuations with a margin of safety due to their targeted credit-profile.