BBDC - Barings BDC: A 12% Yield And Improving Portfolio Quality

2023-10-30 13:12:44 ET

Summary

• Barings BDC offers a high dividend yield of 12.01% with strong net-investment income coverage and potential for further dividend increases.
• The transition to a greater percentage of senior secured lending enhances earnings stability and could attract a broader base of income investors.
• The portfolio consists mainly of senior-secured debt with a suitable interest coverage ratio, reducing the risk of defaults in the face of rising interest rates.

Barings BDC ( BBDC ) currently offers an attractive dividend yield of around 12.01% with very strong net-investment income ((NII)) coverage. The dividend per share has also been on a steady upward trend in recent quarters with the dividend having been raised again in the second quarter. Given the current strong NII coverage there is also clearly some room for further dividend increases.

Furthermore, the continued transition to a greater percentage of its portfolio in senior secured lending should enhance earnings stability. In my view, this lower earnings volatility has the potential to contribute to a long term rerating of the stock as it becomes more attractive to more risk averse income investors.

The portfolio

Barings BDC’s portfolio largely consists of senior-secured debt with around 70% of its portfolio made up of this relatively safer asset class. In its most recent earnings call management also indicated that the median interest coverage ratio for the underlying debtors across its portfolio was around 2.22. While this represents a substantial decline in interest coverage from the first quarter of 2022, when the interest coverage was around 2.9, it remains a suitable interest coverage ratio. In my view, Barings BDCs underlying investments interest coverage is quite impressive when one considers that the Fed has increased interest rates by more than 500-basis points in the current rate hiking cycle.

The interest coverage ratio signals that BBDC’s debtors could withstand some further interest rate increases which reduces the risk of defaults should interest rates remain elevated over an extended period. Inflation has remained stubbornly high despite some signs of moderation in recent quarters. With these higher inflationary pressures interest rates seem unlikely to come down in the near term making it important for investors to monitor the interest coverage ratio of any BDCs they are invested in quite closely.

Nevertheless, some investors might be somewhat concerned about repayments exceeding new originations. In my view, this is not unexpected given the elevated risk in the market at present. Management has noted in this respect that –

Investment activity during the quarter reflected a modest degree of net repayments as reserves -- as returns of capital during the quarter modestly exceeded originations. As our shareholders know, we're actively working to maximize the value in the legacy holdings acquired from MVC Capital and Sierra Income and rotate them into compelling Barings’ originated positions.”

In my view, Barings has always been somewhat more selective with the underlying companies it lends to. While this might slow down capital deployment, I believe it contributes to the strong portfolio which the BDC has maintained with consistently low non-accruals.

The dividend and its sustainability

Barings BDC offers a dividend yield of around 12% which is the second highest dividend yield among the major BDCs included in the peer-comp chart below. This is broadly in-line with the BDCs 5-year average dividend yield of around 11.95%.

In the second quarter the BDC increased its quarterly dividend per share to $0.26. This dividend increase was backed by reported NII per share of around $0.31 representing a 119% dividend coverage ratio. The BDCs 1-year average NII coverage ratio of around 117% also comfortably covered all dividends paid so far this year.

The recent dividend increase also does not stand in isolation, with Barings BDC having increased the dividend several times in recent years. Since its establishment in its current form in 2018, the BDC has reported frequent dividend increases having grown the quarterly dividend from around $0.1 per share at the time to the current $0.26 per share.

These dividend increases have been supported by consistently strong NII. The current high coverage ratio also leaves some room for further dividend growth even if NII were to remain stable. At present high interest rates have benefited BBDC given the high percentage of its portfolio composed of floating rate investments. Therefore, while interest rates could present a challenge to some borrowers’ ability to repay it is also positive for BBDC’s NII.

Declining interest rates could bring about some declines in NII. However, at present I expect interest rates to remain elevated for a longer period of time given the continued high inflation levels. Nevertheless, I also don’t foresee much further interest rate hikes in the quarters ahead signaling that the bulk of the accretion to NII growth from higher interest rates has likely passed. In my view, the bulk of NII growth in the quarters ahead will likely arise from the continued redeployment of the Sierra portfolio into Barings originated investments.

Valuation

Barings BDC is trading at a 13% discount to NAV which is around the middle of the pack of the major BDCs considered in the peer comp chart below. This is broadly in line with its 3-year average discount to NAV of around 15%.

These valuation levels appear quite attractive particularly as the BDC has become a much higher quality BDC since changing its manager to Barings. The successful shift from a portfolio that had a high percentage of broadly syndicated loans (which is a more volatile asset class) to a portfolio that is dominated by less-volatile senior secured loans should contribute to a long term rerating of the stock. In my view, this change could see a greater number of more risk-averse income investors investing in BBDC.

Conclusion

Barings BDC presents a compelling investment opportunity, with an attractive dividend yield of 12.01% and a strong net-investment income coverage. The steady increase in dividend per share over recent quarters, coupled with the potential for further growth, adds to its appeal.

The portfolio composition, with a significant portion in senior-secured debt, reflects a prudent approach to risk management. Despite a slight decline in interest coverage ratio, the underlying investments demonstrate resilience in the face of rising interest rates. Furthermore, while the benefit for NII that has been obtained from higher interest rates has likely passed, the continued redeployment of its portfolio into Barings originated investments offers new avenues for NII growth.

Trading at a 13% discount to NAV, Barings BDC offers an attractive entry point for potential investors. The transition towards a higher-quality portfolio suggests the potential for a long-term rerating of the stock, potentially drawing in a broader base of somewhat more risk-averse income investors.

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