September 2016 Business Development Company (BDC) Market Update
Senior Portfolio Specialist Allen Webb talks with Senior Investment Analyst Andrew Kerai about the business development company (BDC) market for the month of September 2016.
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[BEGIN VIDEO TRANSCRIPT]
ALLEN: Andrew, let’s talk about business development companies, maybe starting out with an update on total returns from a year to date perspective.
ANDREW: Sure. The BDC sector continues to grind higher here as we approach the end of Q3. To open the year, discounts were about 14 percent wide. On February 11th, which was the bottom for pretty much all risk assets, high yield, equities, BDCs as well, discounts were 25 percent. Now, they’re only four percent discounts on a market cap weighted basis. Year to date, the total return for BDCs is about 18 percent, which compares favorably to the S&P, and slightly favorably to high yield as well.
ALLEN: Andrew, talking about the four percent discount to book value, can you talk a little about- is that pretty uniform across different types of BDCs, or is there some differentiation in discounts depending on what type of BDC it is?
ANDREW: Sure. I think there’s definitely been a bifurcation in the market for a while, meaning the higher quality BDCs with strong distribution coverage, higher quality portfolios tend to trade at a material premium to the sector average, and I think that remains the case today. You look at the other end of the market, where it could be dividends not being covered, a fee structure that’s not aligned, a manager that’s got a favorite portfolio that’s had issues. Perhaps some or all of the above will trade at a materially wider discount, typically even in this market amidst this rally.
ALLEN: Before we leave valuation, talk about from a historical perspective, has the average discount actually been a premium historically, or are we approaching the upper bound of where BDCs can trade?
ANDREW: I think if you look historically, BDCs typically trade right around NAV. I think, I believe the actual market cap weighted average is about 102, so we are approaching the long-term average. Obviously, if you strip out 2008 and 2009, that adds a couple of points to that, but I think, if you look historically, we are approaching the long term average, but not quite there yet.
ALLEN: Do you have any thoughts on why the big rally from mid-February- is this a case of risk on and business development companies are lumped in with that grouping, or is there something about how stretched valuations became, or other factors that have led to the rally?
ANDREW: I think the two things that are really driving the BDC sector rally overall, one is rates continue to come in. If you look, from the beginning of the year, the yield curve has both flattened, and the longer the curve has moved down about 70 bps, so the way I look at it is if you were to look at the duration impact of that on products, looking at just high grade corporates are up about nine percent total return for the year, and looking at our market being up about 18, high yield about 15, you can say there is call it six to eight percent is the beta rally, which is where the S&P is actually up for the year. I would say it’s a combination of a duration rally within rates as well as a beta rally within U.S. risk assets.
ALLEN: Andrew, you brought up rates, and certainly that’s something on a lot of investors’ minds. I have a two-fold question for you. First off, certainly, Fed did not raise in September. There is certainly some speculation that they could raise in December. If they do, any negative effect, or any effect at all on the BDC market?
ANDREW: I think from a fundamental perspective, the majority of BDC portfolio assets are a floating rate. It’s about 80 percent floating rate assets to get on a market cap weighted basis. It’ll differ by BDC. Some are 100 percent floating. Some are more 50/50 floating to fix. Some actually have a higher mix of fixed. On a market cap weighted basis overall, the sector has certainly shifted to a preference for floating rate assets and fixed rate debt. I think if you look at the BDC market, there are what’s known as LIBOR floors in the majority of the loans, typically 100 to 125 basis points, so now, what’s really critical for a BDC just from a fundamental earnings perspective is what happens to three-month LIBOR, which has gone up to about 88 bps now. I think if you look at the fed raising rates another 25 bps, you start to get beyond the LIBOR floors in the loans, which means all things being equal, you start to have potentially some modest earnings accretion from just a fundamental rate point of view. I think when you talk about how does that impact stock values and discounts or required yields, I think that remains to be seen. However, I think if you look at the Fed’s comments, what you’re going to see is this is what most people would agree is a very dove-ish sort of measured, potentially rate hike environment, meaning we entered the year thinking we were going to have four rate hikes. We haven’t had one yet. If you look at the probabilities, now it’s about 50-50 to raise 25 bps in December, so I think clearly there is a much more dove-ish sentiment overall, meaning that I wouldn’t expect there to be necessarily the shock that you would see in a taper tantrum type environment that we saw about three years about, but that again will remain to be seen as that unfolds throughout the rest of the year.
ALLEN: Andrew, the second derivative of this question is what about the shape of the curve? You touched on this a little bit earlier, that we’ve seen some flattening. Is the shape of the curve something that you watch more closely than the actual overall level of rates as relates to BDCs?
ANDREW: I think that’s a great point. Again, the BDCs are especially sensitive to the front end of the curve, meaning three-month LIBOR. The yield curve, if you look at the front end of the curve, it’s basically been where it was at the end of last year. What has flattened out is the end of the curve, which of course means that people are expecting rates to stay lower for longer. If that’s the case, then all things being equal, one would expect yield-oriented products, BDCs, mortgage reads, etc., to remain relatively attractive, given that the yield spread over alternatives in the market will remain relatively wide for a longer period of time. The other part of your question, I think, is interesting too, is you’ve seen multiple BDCs cut dividends so far this year. I think the reality of this market is we are in a lower rate for longer environment, according to most people, which means that, all things being equal, as BDCs continue to rotate out of older assets at higher spreads, there is going to be pressure on the earnings profile of certain BDCs, given that the expense structure of – and certainly a managed BDC – is going to be fixed.
ALLEN: Andrew, last question. Talk about credit quality for a minute. As you look at BDC portfolios and you break those down, anything to note, either positively or negatively as it relates to credit metrics or trends you’re seeing from a credit standpoint.
ANDREW: I’d say at a high level, credit remains relatively benign. If you look at it from a mark perspective, BDC marks went up about seven tenths of a point to just over 93 on a market cap par weighted basis this past quarter. Non-accruals remain historically low, about two percent on a fair value basis, four percent when measured at cost. Again, I think it’s very much BDC-specific, meaning there are certain BDCs that are having a relatively high level of credit issues, whether it be energy, legacy assets, just poor underwriting, and then there are certain BDCs that have no non-accruals, have portfolios at 97 or 98, pretty much clean books. So, unlike the liquid markets, where there is a higher degree of correlation among different funds, within BDCs, these are for the most part privately directly originated assets where the range of outcomes can be, for example, a zero recovery for a first lien asset to a portfolio that’s throwing off seven to nine percent total return quarter after quarter with relatively modest loss at this point in time.
ALLEN: Andrew, thanks as always for your comments.
ANDREW: Thank you.
[END VIDEO TRANSCRIPT]
Video recorded 9.29.2016.
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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.
Definitions
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.
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. Investment Grade Corporate Bonds: The BofA Merrill Lynch US Corporate Index. BB Corp Bonds: The BofA Merrill Lynch BB US High Yield Index. B Corp Bonds Bonds: The BofA Merrill Lynch Single-B US High Yield Index. CCC & Below Corp Bonds: The BofA Merrill Lynch CCC & Lower US High Yield Index. The indices cannot be invested in directly and do not reflect fees and expenses.
Book value is the value at which an asset is carried on a balance sheet.
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.
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.
Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates.
Beta reflects the sensitivity of a fund’s return to fluctuations in the market index. A beta of 0.5 reflects half of the market’s volatility as represented by the Fund’s primary benchmark, while a beta of 2.0 reflects twice the volatility.
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.
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.
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.
Fed Taper Talk: Federal Reserve Chairman Ben Bernanke announced that the central bank would begin paring back its $85-billion-a-month bond-buying program should the economic data continue to improve. This caused an aggressive stock market sell off and an increase in interest rates.
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.
At par is a term that refers to a bond, preferred stock or other debt obligation that is trading at its face value.
After 90 days of nonpayment, a loan is placed on nonaccrual status, and interest stops accumulating. The bank classifies the loan as substandard and reports the change to the credit reporting agencies, which lowers the borrower's credit score. The lender changes its allowance for the potential loan loss, sets aside a reserve to protect the bank's financial interests and may take legal action against the borrower.
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.
Distribution Yield based on current price and last distribution. Total distribution yield – this is calculated by taking the last declared distribution (including all elements: Income, capital gains and return of capital) then annualizing the amount (i.e., multiplying by 4 for a quarterly paying fund; by 12 for a monthly paying fund). The total distribution amount is then divided by the current share price and multiplied by 100 to arrive at a percentage figure. Year-end “special” distributions are excluded – i.e. the yields are based on recurring distributions only.
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.
