We believe BDCs are built to deliver dividends in a recession

 Author: 

Michael C. Petro, CFA | Portfolio Manager

Since the close of the 2022 third quarter, stocks of business development companies (BDCs) have outpaced most investment classes, surging 23.0% as of 2/28/23. They have recorded a healthy 7.4% average annual total return since the end of 2019, shortly before the pandemic began, as measured by the S&P BDC Index.

A BDC is a company that seeks an attractive level of income by providing financing primarily to privately held small and midsize companies. Net interest income, after management fees and expenses, is passed on to BDC equity investors via regular dividends. In times of equity market volatility, a stream of current income may provide a base level of return and add some ballast to portfolio performance.

BDCs and the challenges of today’s equity market

With the Federal Reserve aggressively raising interest rates, even at the risk of pushing the economy into recession, investors may wonder how BDC stocks might fare in a recessionary environment. BDC equities have been volatile in past periods of economic contraction, as investors priced in the effects of potential credit losses on BDC book values. For example, BDC book values traded down during the 2020 pandemic on fears that steep losses would be forthcoming, though the stocks rebounded quickly once the economy stabilized. While we would expect BDC stocks, like most equities, to decline in the event of a recession, we don’t believe the drawdown would be as dramatic as in the past.

We believe any recession in the near future is unlikely to be as dire as the global financial crisis of 2008 or the exceptionally steep, although brief, pandemic-driven downturn of 2020. Therefore, we would expect BDC credit losses to be milder in the event of a recession today. Furthermore, we believe BDCs are fundamentally better prepared for an eventual recession than they have been in years past. We also believe that their dividend income would be largely preserved.

BDCs have evolved to better withstand a recession

One likely source of BDC equity volatility is the fear that BDCs could suffer book value destruction from losses on the loans they have made to their middle-market borrowers. Also, some may worry that BDCs could face a liquidity squeeze if their own lenders should retract the secured credit lines made to the BDCs.

These are legitimate concerns, but BDCs have evolved their lending and borrowing practices to help mitigate such risks. For example:

BDCs have shifted their lending focus. They have moved up the capital stack toward safer first lien loans over the past decade.

They are lending to larger, more resilient companies to reduce risk of default. Among the six largest BDCs, the average client company EBITDA has increased from $61 million in 2016 to $75.5 million in 2019. We believe this trend extends more generally across the BDC space.

They have significantly improved their balance sheets. In the global financial crisis, and to a lesser degree in the pandemic recession, a few BDCs felt a liquidity pinch. The downturns caused them to bump up against covenant limitations in their secured lending facilities. Today’s BDCs have constructed their balance sheets in ways that better protect investor equity in a downturn. They have termed out more of their debt a few years farther into the future than was previously typical, which greatly reduces the likelihood of near-term funding pressure. More important, they have substantially reduced their reliance on secured debt, as demonstrated by unsecured debt moving from only 6% of total debt in 2007 to a healthy 57% in Q3 of 2022. While unsecured debt is more expensive than secured credit, it does not have the marks-to-market on assets that can threaten credit availability in times of distress.

Our outlook for BDC dividends remains constructive

BDC investors are currently enjoying the benefits of the Fed’s rate-hike regime, which can boost BDCs’ profitability due to their typically asset-sensitive balance sheets. If rates retreat in a recession, as they usually do, what would happen to BDC dividends? While BDCs would feel an impact from any rate decline, we believe BDC dividends would remain at highly attractive levels.

• In the near term, BDCs should continue to benefit from rising rates, as actual BDC lending rates, which are indexed to the Secured Overnight Financing Rate (SOFR), can lag base rate action by at least a full quarter, and the Fed is still indicating a bias toward additional increases.
• When rates decrease, we expect BDC dividend coverage will decline, but from a level higher than today. This is supported by the natural repricing over time of BDC loan books to more recent higher-spread loans, and by contractual rate floors BDCs often have on their loans.
• With the help of a December 2022 Raymond James analysis of 24 BDCs that looked at forward rate expectations, we estimate that S&P BDC Index earnings would exceed December’s dividend levels by 40%. And even if short-term rates (SOFR) fall to 1%, earnings would still fully support those dividend rates. When further accounting for an estimated 5% to 6% loss to BDC equity in a recession, we believe S&P BDC Index earnings would still be more than 90% of year-end 2022 dividend levels.

In all market environments, BDCs offer the potential for attractive yields, as they are required to distribute at least 90% of net income to shareholders. They operate in a market segment where there are fewer lenders, thus the higher yields. BDCs also offer diversification benefits, with a historically low correlation to other asset classes. Investing in a portfolio of BDC stocks offers diversification advantages over owning an individual BDC stock.