May 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 May 2016.
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[BEGIN VIDEO TRANSCRIPT]
ALLEN: Andrew, when we last got together in late March, early April, we were coming off a quarter for capital markets volatility. Business development companies or BDCs also had a pretty volatile first quarter, so now that a couple of months have gone by, can you talk about BDC performance and sort of some high level takeaways from the last couple months?
ANDREW: Sure. So BDCs typically report their quarterly metrics about a month or so after the end of the quarter. They’ll file the Q and, for example, for March 31st, you’ll get the majority of the BDC data out the first couple weeks of May. When you look at that backdrop overall, on a market cap weighted basis, BDC NAVs down about 90 bips on the quarter, total return of about 1.2 percent or 5 percent annualized when you factor in distributions. Trailing one year is going to be about a 3 percent—or 3 percent ROE. Factoring NAV declines about 5 1/2, offset by distributions of about 850 basis points. I think when you look at that backdrop, certainly the correlation comes to high yield. In the first quarter, high yield was down significantly through the middle of February. BDC discounts at that point were about 25 percent wide. It was about 10 points in from 15 percent discounts at the start of the year, now all the way back to 10. If you look, high yield is actually up about 10 percent for the year when it had bottomed around that exact same time period. Loans, which tend to be a less volatile asset class, being secured in the capital structure and floating rate, had spreads widen out about 100 bips and then actually come back and tighten for the year if you look at the year to date numbers now.
ALLEN: Okay, Andrew any themes from quarterly earnings across the entirety of the BDC space, including you know, higher quality managers all the way down to some of the lower quality managers?
ANDREW: Sure, so I think the key theme in the sector continues to be differentiation both by manager and portfolio quality. You saw, for example, some higher quality names with a higher mix of senior secured loans. More conservative underwriting, quality managers. Then actually saw NAV appreciation during the quarter in a really attractive ROE profile. Conversely you saw some portfolios that consisted of more stressed names, maybe lower quality of the manager, that had continued to have NAV runoff now for five, six, seven quarters. I think, you know, clearly the market is giving the differentiation in valuation from that perspective. There are a handful of externally-managed BDCs with relatively higher quality portfolios, perceived higher manager quality, trading at a premium. There are BDCs that are still trading at 34 percent discounts.
ALLEN: Andrew, for our viewers that know RiverNorth, clearly would understand why we might have some interest in BDCs at discounts to NAV of maybe 25 percent. But as we are now averaging 10 percent discounts, can you talk about the opportunity set a little bit... should investors find interest now that discounts have narrowed from where we came to the year?
ANDREW: I think the answer is absolutely, and I think the reality is while we’re talking about a market cap weighted basis here at a 10 discount, there are opportunities where we view the market is misvaluing the portfolios of certain BDCs. These might be smaller names that are perhaps not as liquid as some of the larger cap names. They might not get as much attention to where the motto of diligence really does work, and even I think as you look at the larger cap names, we would view that either it’s a manager misvaluation or a portfolio misvaluation where we feel like is the best opportunity set for BDC investors.
ALLEN: Andrew, last question, certainly business development companies fall into the credit world, so if you think about BDCs relative to, maybe, high yield and bank loans, which are probably other things people can invest in, is there anything that would tilt you towards BDCs from a valuation standpoint, or is it simply doing your bottoms up homework and you can’t really make a decision on BDCs versus other asset classes?
ANDREW: Sure, so I think a couple of things. BDCs primarily invest in directly originated middle-market loans. Movements in pricing in the liquid markets, and boradly syndicated loans and high yield, are typically driven by a lot of technical factors, right? CLO formation, buying and selling of assets, inflows and outflows of open-end mutual funds that invest in high yield. Middle-market or BDC assets' performance is typically driven by idiosyncratic credit events, so yes, if there is spread widening and tightening, you will see that impact on pricing within BDCs navs, but if you look over time, the majority of the performance of a BDC’s portfolio is driven by credit events, so I think the reality is when thinking about a relative value of liquid high yield credit versus BDCs, I think clearly there is a high correlation between both markets, but I think when you, to your point, Alan, when you take a look at doing the bottom up work on the portfolio companies themselves, figuring out where we feel a true NAV is for the particular BDC and an appropriate error of—or an appropriate margin of error, I should say, that’s where the value is. I would agree that, clearly, if bank loan closed-end funds or high yield closed-end funds are trading at a discount, typically BDCs would be as well, too, but there have been times when, for example, the BDCs were removed from the Russell indices two years ago, BDCs just widened out 10 points on technical factors, when it really didn’t reflect any weakness in the high yield markets, but that was an example of a technical factor that drove this sector down.
ALLEN: If I hear you correctly, BDCs aren’t necessarily mispriced versus bank loans or high yield, but certainly as you look at specific BDCs versus bank loans and high yield closed-end funds, there are some opportunities.
ANDREW: Correct, that’s exactly right, and clearly, as you differentiate across a BDC sector, those that are more upper, middle-market, quasi broadly syndicated loans or are getting close to that EBITDA level, they will have more of a correlation with the liquid markets than some of the lower middle market smaller BDCs would.
ALLEN: Andrew, thanks as always for joining us this month.
ANDREW: Thank you, Alan.
[END VIDEO TRANSCRIPT]
Video recorded 6.14.2016.
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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.
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.
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.
Par is a term that refers to a bond, preferred stock or other debt obligation that is trading at its face value.
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.
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.
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.
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.
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.
EBITDA is earnings before interest, taxes, depreciation and amortization.
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.
