BDC Market Update: 12.20.2016
Sr. Portfolio Specialist Allen Webb sat down with Sr. Investment Analyst Andrew Kerai to talk about the business development company market for the last quarter.
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[BEGIN VIDEO TRANSCRIPT]
ALLEN: Andrew, let's talk about the Business Development Company — or BDC — market for a little bit. Since the last time we got together, we've seen a pretty significant rally from the equity side of the world, as well as the credit side of the world. Equities had one of the better months of the year in November. Spreads have narrowed a little bit, and it’s been a risk-on environment. How has that translated into the BDC market?
ANDREW: Sure. Certainly, thematically the same in the BDC market as well. BDCs tend to be highly correlated to high yield, but the volatility tends to be higher. Typically, when you see the market rally, you see BDCs outperform, and vice versa. It's certainly been the case in this sector rally. BDCs now, year-to-date at about 24 percent. They were about 8 1/2 percent during Q3, and about 5 percent post quarter-end.
ALLEN: Andrew, let's talk about credit trends a little bit. Certainly risk-on, a rising tide lifts all boats, but have credit trends improved alongside of the market rally, or in your opinion has the market gotten a little ahead of where we are from a credit standpoint?
ANDREW: Sure. Certainly, in the liquid markets, credit continues to grind higher. Certainly, if you’ve looked at the high-yield markets, even with rates coming out here over the past couple of months, you've seen spread tightening overcome that, and actually high-yields posted a positive total return, if you look over the past couple of months. I think if you look at the BDC sector, generally speaking, you're seeing the same types of trends. I think there are certain portfolios that are chunkier with lower-quality assets that have continued to underperform, but I would see those as idiosyncratic events in certain portfolio companies. I would say, broadly speaking, the trend you're seeing within the high-yield market, you’re seeing transfer over to the BDC market. Just to put a number on it, in Q3, for example, you saw a NAV total return of about 3 percent. Overall portfolio values on the debt side of BDC portfolios are about half a point, which drove NAV a little bit under 100 basis points higher in the quarter.
ALLEN: Can you talk about the opportunity set a little bit? In one of the closed-end fund videos we shot recently, we talked about the fact that discounts were getting a little tight, and then there became some fear over interest rates, which we'll talk about in a moment, as well as some uncertainties and fear around the election results, and so that sort of improved the opportunity set in the traditional closed-end fund market. Have you seen the same on BDCs, or has the market literally just been a one-way trade higher?
ANDREW: Yeah. No. Certainly, in the BDC market, it's been, thematically, like the rest of the risk-on universe has been a riding tide lifts all boats. I would say, generally speaking in the space, currently the sector is trading at about right on a market cap basis right around par. To put that in perspective, the sector began the year at about a 12-percent discount. At the February 11th low point, it was about a 25-percent discount, so we've seen basically a 40-percent rally from February 11th until now on a total return basis. Certainly, compared to where we were at the beginning of the year, and for the year so far, we're seeing near-term highs. The sector really has not traded at NAV since 2013. I certainly think the BDC sector has followed the risk-on movement in terms of names reaching all-time highs. The premium names have had larger premiums now, and even some of the names that were discounted — seen as out of favor — have seemed to have caught a bid here.
ALLEN: Does that put a price for perfection in your opinion, though, or is this simply — you know, are you concerned that this may have come too far, too fast?
ANDREW: Sure. I think on a relative valuation basis there are two arguments. One is, you could look at what you're buying underlying assets for — meaning price to book. Then the other side of it is, what is your risk adjusted return within private credit? I think the bulls in the market would certainly make the case that, while yes, there's been a large rally, similarly to other risk-on markets, the total return you're getting from BDC portfolios is still attractive considering the underlying portfolio composition. The other side would say, Well, that may be very well true. However, if your view is that high-yield and spread product in general may be a little bit on the richly-priced side. I think that side of the argument would say that with BDCs trading at or above book, at least for names of quality, perhaps some have maybe risen to a level that might not be as attractive anymore.
ALLEN: Okay. Fair point. Let's talk about two broader themes for a moment. Certainly market participants have been concerned about rising interest rates, really going back to the middle of 2013. Similar fears have finally come to pass in the last six or eight weeks, with rates going from below two on the 10-year to about a two-fifty 10-year. We also had the second Fed funds increase last week, in the last decade. So, thinking about that in terms of the BDC market, people tend to think of that as a credit market, but can you walk us through how rising rates at various parts of the curve affect this market?
ANDREW: Sure. BDCs are highly sensitive to three-month LIBOR. About 80 percent, on average, of BDC loans are floating-rate tied to LIBOR, typically with a floor of about 100 to 125 basis points. Now we're seeing three-month LIBOR approaching 1 percent. I think it's 99 basis points today, which means, incrementally speaking, it's fundamentally positive for BDCs, meaning their earnings actually rise in a rising LIBOR rate environment, which obviously is at the very front of the curve. That's the fundamental earnings side of the equation. The other side is, how do BDCs trade and how are they valued when the curve shifts south? I think historically what you’ve seen is, BDCs have kind of been group into yield categories, within REIT's high-yield, etcetera. Now what I think you're seeing is, while rates have certainly moved up — the five-year is up about 70 bps plus over the past couple of months, you actually have seen BDCs perform well, and generate a positive total return, along with high-yield bonds. The question is, why is that? Well, if you look at spread tightening within high-yield versus rate movements, the spread tightenings actually overwhelm that. So, I think it's somewhat maybe early innings to figure out how BDCs are trading at a new normal of rising rates, given the historical precedent, but I think given that the risk-on environment has only strengthened, while the rate environment has shifted up and steepened, BDCs like high-yield have actually performed well, despite the yield curve shifting up.
ALLEN: So, fair to say that if we sort of simplify the world into exposure to credit and exposure to rate sensitivity, BDCs certainly fall in the exposure to credit, so, again, if you're selecting between those two types of fixed-income environments, BDCs look possibly attractive versus some things that are purely interest rate sensitive.
ANDREW: Sure. That's correct. If you're looking for low duration and positive exposure to credit spreads, certainly the BDC market, like the bank loan market, will fall into a category that you would likely find attractive.
ALLEN: Great. Last question for you, Andrew. So, we had an election about a month and-a-half ago, and we have a new President-elect in Donald Trump. The result was a little surprising. So, can you talk about, as you project forward, taking office, we have a Republican Congress. We also have some look into the types of people that he is naming to some pretty key posts. It seems like we're heading down a path of de-regulation, possibly. Can you talk a little bit about that, and how that might possibly affect something like the business development company market?
ANDREW: Sure. It's a great question. One of the beneficiaries of, effectively, the bank regulatory environment, sort of post-crisis, has been BDCs. The reason why is, basically, if you look at banks’ share of level 3 or illiquid assets, they’ve consolidated as you’ve had tougher capital rules coming down the pipeline, stricter capital treatment of liquid assets — banks have largely shied away from middle-market or liquid credit. This allows BDCs to fill that void, and find presumably better risk reward, given they’re coming in and providing liquidity to borrowers who were effectively being turned away from the banks. The thinking is, if that does change — if banks sort of dip their foot into level-three liquid middle-market credit — it's obviously going to become an even more competitive environment for BDCs. Again, just to be clear, it's certainly not clear at this point to the extent that happens. It’s obviously still early innings in terms of thinking about how that takes place. I was just at a BDC conference a couple of weeks ago, and the theme was, there's a whole different underwriting and origination mentality of the type of assets BDCs put on their balance sheets. It's middle-market, direct origination, working with private equity sponsors, which is a different infrastructure than sort of a check-the-box bank mentality. I'm not sure if, or how quickly, that could potentially shift, but in my view it's a little premature to sort of draw any conclusions for that. Certainly, BDCs — and just non-bank finance in general — have been beneficiaries of bank regulation. To the extent that part of that unwinds, we could see a more competitive environment for middle-market credit.
ALLEN: In which case, do you think that becomes somewhat of an opportunity for investors, in that now you have 40-plus publicly-traded BDCs possibly. Does that create an environment for more? Does that create a difference of opinion in different levels of trading for all the BDCs out there? What's sort of the secondary effect of that?
ANDREW: Sure. I think if you look at one potential comp to a situation like that, it’s what we’re seeing right now. It's a fact that middle-market credit has become much more competitive. You've had additional funds launch and raise more assets both inside and outside of the BDC market, and what does that typically mean? I think you see it in terms of, certainly, spreads coming in, additional leverage on the underwriting — you know, you’re seeing certain lenders stretch. I think the reality is certainly if there's more competition, that could presumably create a market to where there is even more differentiation among underwriting and credit performance, potentially some more yield compression, and potentially even discussion around how does the expense structure of a proper BDC look? Meaning yes, if you're underwriting quality paper at spreads of 800 basis points, obviously you can have an expense structure that supports that, if that comes in, then obviously the expense structure, I would think, would have to come in as well, to make the math make sense from an investor's point of view.
ALLEN: So, to sum up, between the recent risk-on environment and performance, between rates rising a little bit, finally after years of speculation, and now the potential of some deregulation in the banking industry, it sounds like it's a pretty interesting time to be a BDC investor.
ANDREW: Certainly. It's been an interesting year, both from a performance standpoint — the BDC markets, you know, just like the risk of the risk-on environment. It's certainly been a great year for BDC performance. We just saw, actually, the two largest BDCs gain shareholder approval to merge into the larger BDC. That was the largest M&A deal to ever happen in the space. So, we're seeing a lot of different moving parts in the BDC universe. You're seeing, I think, this new competitive environment of tighter spreads in the middle market. You're seeing, obviously, on the regulatory and macro side, the different things happening there — rates going up for the first time since the crisis, so I think you're seeing a bunch of different pieces moving internally in the sector, as well as certain one-off events, and then the macro environment. I'm certainly looking forward to seeing how 2017 — how these different pieces kind of come together, and seeing how the market responds, and seeing how fundamentals play out from the credit side in the new year.
ALLEN: Andrew, thanks as always for your time.
ANDREW: Thank you, Allen.
[END VIDEO TRANSCRIPT]
Video recorded 12.20.2016.
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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.
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 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 BofA Merrill Lynch US Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with at least one year remaining term to final maturity. The indices cannot be invested in directly and do not reflect fees and expenses.
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.
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.
At par is a term that refers to a bond, preferred stock or other debt obligation that is trading at its face value.
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.
Book value is the value at which an asset is carried on a balance sheet.
The federal funds rate is interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight.
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 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.
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.
Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates.
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.
Level 3 assets are assets whose fair value cannot be determined by using observable measures, such as market prices or models. Level 3 assets are typically very illiquid, and fair values can only be calculated using estimates or risk-adjusted value ranges.
Mergers and acquisitions (M&A) are transactions in which the ownership of companies, other business organizations or their operating units are transferred or combined.
The financial crisis of 2007–08, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.
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 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.