This article was first released to Systematic Income subscribers and free trials on Mar. 11.
Welcome to another installment of our BDC Market Weekly Review, where we discuss market activity in the Business Development Company (“BDC”) sector from both the bottom-up – highlighting individual news and events – as well as the top-down – providing an overview of the broader market.
We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the second week of March.
Be sure to check out our other Weeklies – covering the Closed-End Fund (“CEF”) as well as the preferreds/baby bond markets for perspectives across the broader income space.
This week reminded us of a show called “And Now For Something Completely Different”. BDCs had a strong start to the year until it all disappeared in a period of just 2 days. Interestingly, BDCs were the week’s worst-performing income sector in the chart below. The key drivers of this underperformance were the relatively higher-beta of the sector as well as the drop in short-term rates as 1Y Treasury Bill yields fell by 0.35% (to where they were about a month ago).
The 2-day drop in the sector was the sharpest over the past year and takes us to around the midpoint between the recent high and the October low.
The sector valuation now stands around 90%. A further move below 90% would make us bullish on the sector, particularly in light of further net income raises we expect in Q2.
A common BDC price dynamic that our readers are likely already familiar with is the tendency of higher-valuation BDCs to underperform in periods of market weakness. This is precisely what happened over the last two days of the week when the sector fell around 10%. The relationship is not perfect but BDCs with higher valuations right before the drawdown tended to have larger price drops.
For example, HTGC (which was trading at a valuation north of 140%) fell nearly 20% while other above-average valuation BDCs like TPVG, TRIN, HRZN and GAIN all underperformed with double-digit drops. It’s true that investors probably had more concerns about HTGC which is focused on the Tech / Venture ecosystem – the area that was most impacted by the SVB fallout – however, HTGC itself was not directly impacted.
What this dynamic suggests is that higher-valuation BDCs tend to be more vulnerable to a downshift in sentiment and it can make sense to wait for a dip before allocating to these BDCs. It also means that BDCs that already trade with a margin of safety can be more resilient through downturns. Of course this doesn’t imply investors should only allocate to lowest-valuation BDCs (which are often value traps) but that valuation remains a key consideration for allocation within the sector.
Goldman Sachs BDC (GSBD) sold 6.5m shares ($99m gross proceeds + greenshoe of 0.975m shares). There was the usual drop after the news with a 6% dip in the price. GSBD has been an odd one – it has tended to trade at an elevated valuation despite fairly middling performance. Even after the drop, its valuation remains 3% above the sector average. I
Its unusually low valuation spread percentile of 1% means it has basically never traded cheaper than the sector. Again, pretty odd given its 1% per annum underperformance over the past 5 years in total NAV terms and a 0.4% underperformance (larger on a median basis) over the past 3 years. At the current price it’s still expensive.
There was some reader engagement with our BBDC commentary that another analyst viewed it as the most attractive BDC at the moment and recent underperformance (by a third over the last 3 years in total NAV terms) was largely due to the company “digesting” a merger.
Occasionally you hear arguments that sort of sound sensible in passing but don’t actually stand up to scrutiny. First, the argument that BBDC has underperformed only because management is busy with the merger says something terrible about the quality of management. It seems to imply that management can’t be bothered actually running a BDC (their only job, mind you) because they are busy dealing with the merger.
And second, BBDC is not the only BDC that is going through mergers. OCSL is going through its second merger, not to mention, a total takeover of a third-party portfolio several years back. Despite that it’s performed much much better. Ultimately, underperformance is not great and investors should be critical of the reasons offered for them.
Stance And Takeaways
Earlier this week and, fortuitously, prior to the sharp drop in the last two days, we continued our recent theme of marginally rotating away from BDC common shares to baby bonds (both in the BDC sector and elsewhere). Prior to the drop, the overall valuation of the BDC sector was nudging closer to 100% – roughly its long-term average level which left less margin of safety, particularly in an environment of continued uncertainty about the Fed’s hiking path and its impact on the broader economy. Prior to this rotation we also downgraded all our remaining BDC holdings to Hold from Buy. Now, with a 10% drawdown, we look to reset a number of Buy ratings next week, particularly if we see further weakness.