Sr. Investment Analyst Andrew Kerai provides an update on the BDC market for the last quarter.
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Allen: Andrew, January and February saw capital markets have pretty positive performance. It's been kind of a risk-on mentality ever since we entered the first of the year. Can you talk a little bit about how that's filtered into business development company total returns as well as discounts to net asset value?
Andrew: Sure. It certainly has flown through to the BDC market. Overall in 2016 you saw BDCs up 24 percent. Year to date, they're about 5 percent. From a valuation perspective on a market cap weighted basis trading at about a 5 percent premium, which if you look at about a year ago, this market overall had a 25 percent discount. From a total return perspective off the low in February of last year you're up - call it 40 percent-plus - when you think about the space, you sort of go down your fundamental checklist of quality manager, quality book, stable earnings, and, frankly, the names that fit in that category in many cases are trading at double-digit premiums. Certainly the sector has gotten a strong lift off the sentiment rally. We've also seen some dedicated capital coming into the space and, when you're talking about sizeable capital that's dedicated long only BDC money and it's a $30 billion market cap universe of 50 names, you kind of create what I call the perfect tailwind of strong risk-on sentiment, appetite for floating rate credit, as well as just some additional capital flowing into a small space.
Allen: On that last point, on a momentum trade, can you look across the forty, 50 or so publicly-traded names and sort of discern value or is simply positive returns from here driven by momentum in the space?
Andrew: Sure. Certainly the momentum trade has played out. I think we've seen that for the past couple of quarters. The reality is finding value in the space right now is somewhat difficult. I would agree that returns from here likely are driven by positive momentum, i.e. continued risk-on rally, credit continuing to tighten, as opposed to really a valuation mean reversion-type trade at this point.
Allen: Has this been a "rising tide lifts all boats" rally in that BDCs that maybe are less interesting to you from a fundamental standpoint have performed just as well as BDCs that are a lot more interesting to you from a fundamental standpoint?
Andrew: I would say generally yes. Some of the lower-quality BDCs certainly have gotten a bump with the market, with a couple of small exceptions of names that have just — the performance has been so bad that they've managed to override the overall sector rally. I would say generally speaking it has been a rising tide lifts all boats, absent a couple of outliers.
Allen: Turning to some macro themes... this week the Fed pushed up Fed fund rates and talked a little bit about maybe some future increases. How does that flow through to BDC performance and how you think about the BDC space?
Andrew: Sure. Certainly from an earnings standpoint it's positive. About 80 percent on average of BDC assets are floating rate loans. The majority, typically, of BDC leverage is fixed rate. Certainly from just a mathematical earnings standpoint that's helpful. Most of the floating rate loans are going to have what's known as LIBOR floors that are about 100 to 125 basis points. With LIBOR, at least 3-month LIBOR now at about 115 bips, you're starting to get past some of those floors. We should see a little bit of at least some modest earnings accretion. Certainly from just a mathematical earnings standpoint it's positive. The other side of that question as well — if you are in leverage finance — this goes for the syndicated market as well as middle-market credit — and you're leverage multiples somewhat stretch on the underlying borrower, does that stress the credit quality of your portfolio? What I would say is if you're a lender and you're sitting at the table and saying "Well, this borrower can't support seven times leverage..." the simple fact of rates going up 50 basis points takes some from 5.5 to 7. I think there is an outside chance that you see some rate amendments, but, again I think it's early to tell if there's any negative impact on credit quality. I think you start to see at this point at least some modest earnings accretion now that we're past some of the LIBOR floors.
Allen: That's a good segue into my next question. I think a lot of our viewers are interested in your opinion as you tear apart private credit portfolios, what you're seeing from a credit fundamental standpoint. Are you seeing improvements? Are you seeing deterioration? Is the status quo — can you walk us through kind of what you're seeing at the portfolio level?
Andrew: Sure. It's interesting. Overall it has been a rising tide lifts all boats from just a price valuation perspective. It certainly has not been that way from a credit perspective. You have seen a continued divergence in the market in terms of — The quality managers continue to see strong credit performance generally speaking. Overall you're seeing — credit sort of at a high level is overall roughly flat. You're seeing some spread tightening which has benefited the NAV but also some idiosyncratic credit event in certain portfolio companies of BDCs. I would say generally speaking the good managers continue to see some nav improvement from spread tightening with flat credit metrics whereas some of the lower quality managers that have not underwritten quite as well continue to see some NAV deterioration from just frankly poor underwriting.
Allen: If you had to sum up your view on where we are sort of in the credit cycle — are we in pretty good shape from where you sit? Are we starting to see maybe a negative turn in the credit cycle?
Andrew: I would say overall we are fundamentally sound from a credit perspective. You're seeing earnings growth typically speaking from the underlying portfolio companies. I think fundamentally we are overall in a strong position generally speaking. I think the interesting thing is when you saw the energy crisis that sort of played out in 2015 and part of 2016 you saw — certain portfolio companies that ran into trouble they went through restructurings. I think that's largely — At least it seems to be largely behind us at this point. I think the readthrough going forward is low to medium but still positive growth at the portfolio company level. Overall from a credit picture, it feels like generally speaking we're in pretty good shape.
AllenAllen: Andrew, anything else from a macro perspective that's on your mind as it relates to things that could affect either business development companies themselves or just the sentiment around business development companies? I mean we're 60 days into a new presidential administration. Certainly all of us in the capital markets world are trying to think about changes in policy and how that affects the things we invest in. Does any of that flow through to BDCs? Is there anything you think is sort of worth watching?
Andrew: One dark horse that I've been looking at is just simply talk around tax policy changes meaning — obviously if you look at the potential for the corporate tax rate to be lower that's positive for borrowers, including middle market credit borrowers in the US. However if part of that saving is financed by effectively not allowing interest expense to be deducted going forward that, all things being equal, likely reduces demand for credit from the borrowers themselves. If that were to pull through or if that were to be passed my sort of overall readthrough would be perhaps a spike in refi volumes, lower rates going forward on new loans which would obviously be a headwind for the BDC market. Again, too early to tell if and when tax policy happens or what it looks like. When you start to think about things like a change of sort of interest expense deductibility would obviously have wide-ranging impacts on the loan market.
AllenAllen: Right, and especially I'm assuming for an asset class or part of the market that really thrives on demand at the borrower level, right? If tax policy were to sort of negatively impact demand then certainly that's a challenge for BDCs.
Andrew: That's correct. Anything generally speaking — you're seeing a market that's already quite competitive, right? I mean you've had private capital formation in the space now. The reality is anything that would further pressure rates — I think you start to think about the fee structures of these products and the risk/reward — It's already difficult to make the math work.
Allen: On that note does that mean that as you watch policy that that would impact changes in fee structures for BDCs?
Andrew: I would have to think so just because — there's a certain hurdle, I would say, from an investor's point of view especially with rates going up to where they just say it's not — it just doesn't make sense at a certain point. The reality is anything that would further pressure rates — you're already seeing some fee concessions given that there has been pressure on spreads and private credit.
Allen: Right. Andrew thanks as always for your comments in what's quite an interesting part of the capital markets.
Andrew: Thank you, Allen.
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Video recorded 3.17.2017.
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The price at which a closed-end fund trades often varies from its NAV. Some funds have market prices below their net asset values - referred to as a discount. Conversely, some funds have market prices above their net asset values - referred to as a premium.
The Wells Fargo BDC Index is a market capitalization weighted index of publicly-traded Business Development Companies. The J.P. Morgan Leveraged Loan Index tracks the performance of U.S. dollar denominated senior floating rate bank loans. The BofA Merrill Lynch U.S. High Yield Index tracks the performance of below investment grade, but not in default, US dollar denominated corporate bonds publicly issued in the US domestic market, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P. The indices cannot be invested in directly and do not reflect fees and expenses.
Market Capitalization (Market Cap) is the total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share.
A floating interest rate is an interest rate that is allowed to move up and down with the rest of the market or along with an index.
Risk-on risk-off refers to changes in investment activity in response to global economic patterns. During periods when risk is perceived as low, risk-on risk-off theory states that investors tend to engage in higher-risk investments; when risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments.
A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. Widening credit spreads indicate growing concern about the ability of corporate (and other private) borrowers to service their debt. Narrowing credit spreads indicate improving private creditworthiness.
The federal funds rate is interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight.
Basis Points (BPS or Bips): A common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
A syndicated loan is a loan offered by a group of lenders (called a syndicate) who work together to provide funds for a single borrower.
Refi is short for refinance. A refinance occurs when a business or person revises a payment schedule for repaying debt.
Long only is a feature or policy of certain investment companies. It refers to a policy of only holding "long" positions in assets and securities. To be "long" an asset means being a buyer, generally one who benefits from an increase in prices Book value is the value at which an asset is carried on a balance sheet.
Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage, calculated by dividing a company’s total liabilities by its stockholders' equity. The D/E ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.
A senior bank loan is a debt financing obligation issued by a bank or similar financial institution to a company or individual that holds legal claim to the borrower's assets above all other debt obligations. The loan is considered senior to all other claims against the borrower, which means that in the event of a bankruptcy the senior bank loan is the first to be repaid, before all other interested parties receive repayment.
A collateralized loan obligation (CLO) is a security backed by a pool of debt, often low-rated corporate loans. The investor receives scheduled debt payments from the underlying loans but assumes most of the risk in the event that borrowers default.
Mezzanine financing is a hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full.