Sr. Investment Analyst Andrew Kerai provides an update on the BDC market for the most recent quarter.
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ALLEN: Andrew, when we last got together to talk about business development companies, we talked about capital markets have performed quite well. Equities were up. Current spreads have come in. Rates were sort of trending sideways. Fixed income probably was mostly to the plus side of the ledger. BDCs have performed pretty well. Now we fast forward a quarter, and things are even better. I think the S&P is up about eight and a half percent. High yield spreads are somewhere in the zip code of 400 or so. Interestingly, even with an interest rate increase yesterday from the Fed, rates are down to about 215, or so, on the 10-year. So I guess to kick us off, how has that translated into the BDC market performance?
ANDREW: Overall, the market continues to remain well-bid, trading at about a five percent premium to net asset value. In fact, the first BDC IPO in the past two years just happened yesterday. In many cases, the highest perceived quality issuers trading at double digit premiums, some as high as 20 percent plus. What's interesting, however, is BDCs actually posted their first negative price return on a monthly basis over the past roughly seven months. Last month, they returned about negative six percent, so a significant negative month coming, to your point, on the backdrop of overall capital markets remaining strong, which tends to be unusual for the BDC space.
ALLEN: What would you attribute the cause to the negative performance in light of a pretty positive capital markets backdrop?
ANDREW: It appears to be pretty significantly around earnings. Unlike the past few quarters, where the market gave many BDCs sort of the benefit of the doubt around reported numbers, meaning you had distribution cuts, you had NAVs going down, and in many cases, the market, while it may initially have sold off, absorbed that and the prices came right back, what you saw this quarter around was that if a BDC's earnings were in line with the dividend, for example, they had NAV issues, the prices tended to move down fairly significantly. In my view, what really drove that return came around each BDC reported earnings. The typical scenario was the BDC comes out, the numbers aren't in line with what the market's expecting, investors naturally seeing this market posting at a 50 percent plus return over the past year, and saying does it make sense to trade this name at these kind of levels, and I think investors chose to take some chips off the table, so to speak, around earnings that may have not met the expectations for maybe some of the more optimistic BDC folks out there.
ALLEN: Andrew, I don't think it's any secret, and you have mentioned the fact that there are certainly what we believe to be some high quality managers in the space and some lower quality managers in the space. As you look at the performance differential between that, has that been a rising tide lifts all boats or, as BDCS have performed better and better and better, has there sort of been some distinction between better quality managers and lower quality managers?
ANDREW: For the most part, from a price perspective, I think the answer is yes. From a NAV perspective, not so much. When we spoke last quarter, I would have said that was even more the case from a price perspective. I think, around this earnings season especially, you're starting to see some cracks for the lower quality names that have started to come through. I would certainly say overall, looking at the bigger picture color over the past year or two, it remains a rising tide lifts all boats, but I think you're finally starting to see a little bit of some of the weaker names starting to sell off as they continue to have performance issues, whether it be in credit quality, distribution coverage, or both.
ALLEN: That's a good segue to talk about credit. One thing I think is interesting about what you do day in and day out is you're looking at credit statistics and private credit statistics, and I'm always interested to hear your thoughts. Certainly, there's been some things written recently where leverage in the below investment grade space has begun to rise - or has been rising - and on the flipside of that, some coverage ratios have been coming down, all the while credit spreads, for the most part, have tightened. As you look at the business development company space, how would you characterize credit metrics at this stage of the cycle?
ANDREW: I certainly agree. I think the short answer is the middle market is very competitive, not unlike the liquid market. What's interesting about the comments that you were making in terms of what's going on in liquid credit, you again look 2016 again, a record year for both dollar level of covenant-lite deals as well as mix of covenant-lite deals, so when I think a lot of folks say that first lien is stretching into where the attachment point on second lien has traditionally been, and some of those terms are certainly pulling through, and second lien, a lot of folks, I think, in this side of private creditors saying is more mezz-like than it has been historically, so I think when you put it in that context, it's almost inevitable that the middle market tends to see the spillover impact of what's going on in liquid credit as well. Certainly, the case is BDCs, like other private credit folks as well, too, in the middle market are seeing spread compression and continuing to pull through here. You're seeing the older deals that perhaps came on at higher yields, assuming that they're of quality, are getting paid back and re-fi'd, sometimes multiple times, which is leading to still a decent amount of spread compression in a market that's certainly very competitive. In fact, an interesting data point, even beyond just looser covenants and higher leverage multiples on new deals, some underwriters are now saying that some of the EBITDA adjustments, or adjustments to earnings, from some borrowers, they're sort of add-backs to certain items that would not have traditionally been added back. You're not only perhaps having higher leverage multiples and attachment points than you would have historically, the EBITDA that you're basing that leverage off of, all things being equal, according to many, is actually a lower quality EBITDA than you would have had two or three years ago.
ALLEN: Do you see anything alarming from the credit statistics standpoint, or is this characterized by just late stage of a multi-year credit cycle?
ANDREW: Yes, I think when you look at the liquid markets, it's hard to look at- I believe it's about now 75 percent of the market is cov-lite and first lien, and you did see last year some recovery values on both first lien and second lien deals being below what they had been historically, which would make sense as you're loosening covenants and you have less leverage to pull from an underwriter perspective to be able to maximize your recovery. I think the concerning thing isn't so much in the losses that have bled through across the board yet. I think it's in what could be setting the stage down the road for future losses that is basically, so to speak, sowing the seeds for future losses coming, maybe not so much in the portfolio companies themselves, but maybe in some of the documentation that doesn't have quite as much along the lines of creditor protection that you would expect in, for example, first lien deals.
ALLEN: Andrew, turning our attention to interest rates, as we mentioned in the opening, the Fed raised rates yesterday. The markets not only shrugged it off, but actually, about the time the announcement came out, you actually saw yields coming down a little bit to about 215 on the 10-year. Clearly, the market and the Fed have differing opinions about the level of rates. When you think about just what's happening both from a headline standpoint with the Fed and then what's actually happening in the market, how does the rate situation filter through to BDCs?
ANDREW: The short answer is for BDCs, an increase in the shortening of the curve is good, because the majority of BDC loans floating rate is about 80 percent, and pretty much all of those are tied to three-month LIBOR. As 3-month LIBOR gets above the floors on these loans, it's accretive overall from an earnings perspective, so the short answer is, fundamentally, it is a good thing for BDC earnings for the short end of the curve to be grinding higher. Now, I guess the other part of that question is what happens to BDC or yield products from a pricing perspective is yields rise. Historically, it has not been a good experience for BDCs, REITs, and other yield type plays. I would say that as rates have moved around, at least in recent history, it hasn't quite had the price impact in the BDC market that you would have expected from a historical standpoint. Whether that relationship holds or not over this rate cycle remains to be seen, but certainly, when you're seeing, call it the middle of the curve, coming in off of a Fed rate hike again that just came yesterday, it appears we might be in a low rate environment for a relatively long period of time.
ALLEN: The regulatory environment. I think we talked last quarter about the fact that we have a new presidential administration, or at least we did at the start of the year, and certainly that administration, many of us believe, is a pro-business and less regulatory type regime, possibly. Has that started to show itself in actual regulations that have been passed or have been relieved, or is that still speculation at this point?
ANDREW: One thing the BDCs been trying to pass for a long time is loosening the amount of leverage they are permitted to have on balance sheet, so as the current regulation stands, BDCs are permitted to lever their equity base one times, which is basically double than that of a typical closed end fund, which can lever half the equity base. What BDCs have long been pushing for is to increase that from 1X effectively to 2X the equity base. That has gained traction in the House. The consensus, depending on who you're talking to, is that perhaps doesn't get passed in the Senate, but it feels overall that BDC legislation to that end is in a further place now than what it was before the administration began. Now, whether that's a good thing or a bad thing is depending on your perspective. Naturally, it increases the AUM, all things being equal, of the overall complex of BDC lenders to middle market US borrowers. The other side of that is, obviously with additional leverage, you've going to have more NAV volatility and the like. Depending on how this plays out, we'll see the ultimate impact long-term, and frankly, if the market allows BDCs to increase their leverage, even if they are statutorily allowed to do so.
ALLEN: On that note, if that were allowed, there's obviously always been a lot of scrutiny on BDC fees, and so if the leverage was increased for BDCs, does that necessarily mean more scrutiny on fees now you're earning the same fee on a larger piece of the pie, or do fees need to come down if leverage is regulatorily allowed to go up?
ANDREW: Well, they certainly should. You look at it obviously increasing the AUM of the marketplace, which there's two school of thoughts there. One is we can do lower yielding deals and still generate the same ROE, safer, lower yielding deals...
ALLEN: That's a good point.
ANDREW: ...the other side is that may be true, but some managers may choose to stick with the yield profile of their current deal flow to even further juice ROEs, but also increasing the volatility around that asset value. Then there's even the - I'll call it the third argument - that says, well, all that's going to happen is there's going to be more assets flowing into the marketplace, which means that the same 10 percent deal that you just did previously becomes a seven percent deal. It's effectively you're risking up your balance sheet with just more leverage on your balance sheet. I think depending on what way you look at it, all things equal, assuming that the market does give them access to leverage, it will increase AUM and likely increase fees, but it's sort of you can't have it both ways. If you're a BDC arguing for it allows us to do safer, lower yielding deals, one would think it also comes with a lower fee structure on that type of a product. I guess the short answer is I would hope that certain managers would do what I would call the appropriate thing and reduce fees in that scenario, although I hate to say I'm not confident that all of them will elect to do so.
ALLEN: Andrew, thanks as always for joining us this quarter. It's always good to catch up on what's a very interesting part of the capital markets.
ANDREW: Thank you, Allen.
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Video recorded 6.15.2017.
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Past performance is not a guarantee of future results. Diversification does not ensure a profit or guarantee against loss.
Investing involves risk. Principal loss is possible.
CFA® is a trademark owned by the CFA Institute.
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy based on the changing aggregate market value of these 500 stocks. 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.
High yield bond spreads are the percentage difference in current yields of various classes of high yield bonds (often junk bonds) compared against investment-grade corporate bonds, Treasury bonds or another benchmark bond measure. Spreads are often expressed as a difference in percentage points or basis points.
A 10-year treasury note is a debt obligation issued by the United States government that matures in 10 years. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.
An Initial Public Offering (IPO) is the first sale of stock by a private company to the public.
Leverage is a speculative technique that exposes a closed-end fund to greater risk and increased costs than if it were not used. The use of leverage may cause greater volatility in the level of a closed-end fund's NAV, market price and distributions on its common shares. Leverage will also result in higher fees to the closed-end fund manager because the amount of assets under management will be included in the Fund's managed assets. There can be no assurance that a closed-end fund will use leverage or that its leveraging strategy will be successful during any period in which it is employed.
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 bid is an offer made by an investor, a trader or a dealer to buy a security. The bid will stipulate both the price at which the buyer is willing to purchase the security and the quantity to be purchased.
A covenant is a promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out. Covenants in finance most often relate to terms in a financial contracting, such as a loan document stating the limits at which the borrower can further lend.
A lien is the legal right of a creditor to sell the collateral property of a debtor who fails to meet the obligations of a loan contract.
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.
EBITDA is earnings before interest, taxes, depreciation and amortization.
A credit cycle is a cycle involving the access to credit by borrowers. Credit cycles first go through periods in which funds are easy to borrow; these periods are characterized by lower interest rates, lowered lending requirements and an increase in the amount of available credit. These periods are followed by a contraction in the availability of funds. During the contraction period, interest rates climb and lending rules become more strict, meaning that less people can borrow. The contraction period continues until risks are reduced for the lending institutions, at which point the cycle starts again.
Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value.
Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: normal (steep), inverted (negative), and flat. A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields. A flat yield curve is one in which the shorter- and longer-term yields are very close to each other. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.
LIBOR is the world's most widely-used benchmark for short-term interest rates. It serves as the primary indicator for the average rate at which banks that contribute to the determination of LIBOR may obtain short-term loans in the London interbank market.
A real estate investment trust (REIT) is an investment vehicle for real estate that is comparable to a mutual fund, allowing both small and large investors to acquire ownership in real estate ventures, own and in some cases operate commercial properties such as apartment complexes, hospitals, office buildings, timber land, warehouses, hotels and shopping malls.
Return on equity (ROE) is a measure of profitability that calculates how many dollars of profit a company generates with each dollar of shareholders' equity.
Refi is short for refinance. A refinance occurs when a business or person revises a payment schedule for repaying debt.