TRIN - BDC Weekly Review: An Early Preview Of Q4 Results

Summary

• We take a look at the action in business development companies through the third week of January and highlight some of the key themes we are watching.
• BDCs were flat during the week, with both stocks and Treasuries proving to be mild headwinds.
• Given positive guidance from a number of BDCs, the Q4 reporting season is likely to be a good one for the sector.
• GLAD raised the dividend 7% - another in a series of hikes for the company.
• We expect further dividend hikes in the sector which could fuel another rally. With increasing valuation leaving less margin of error, we plan to reduce sector exposure soon.

This article was first released to Systematic Income subscribers and free trials on Jan. 21 .

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 third week of January.

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. Also, have a look at our primer of the BDC sector, with a focus on how it compares to credit CEFs.

Market Action

BDCs were roughly flat this week as both Treasuries and stocks proved to be mild headwinds. Month-to-date, all but one BDC is in the green with an average return of about 6%. Trinity Capital ( TRIN ) is in the lead, having had a strong bounce from a depressed valuation level late last year. Its valuation is now more or less in line with the sector average level, leaving less margin of safety for its substantial bitcoin mining exposure.

Sector valuation remained steady around 96% this week - a few percentage points below the long-term average. As we discuss below, Q4 numbers posted by BDCs will likely be strong which could further support prices, likely pushing BDCs further into expensive territory.

Market Themes

The Q4 reporting season has not kicked off yet for BDCs, however, there are a number of titbits that we can glean from various sources to get a sense of how it will look.

We got an early preview of the BDC sector earnings season with Saratoga ( SAR ), which reports quarters shifted a month earlier, with the last quarter ending in late November. The numbers were pretty good. There was a 33% increase in adjusted net income (45% increase year-on-year). Number of non-accruals remained the same. NAV was roughly flat.

Ares Capital ( ARCC ) provided Q4 guidance in relation to its public offering. Core EPS is expected to come in with a double-digit jump while the NAV is expected down a bit less than 1%.

Main Street Capital ( MAIN ) is another BDC that disclosed Q4 estimates in relation to a change in its financing. The NAV is up 3.5% and net income was up by 17%.

While this sample is admittedly small we are seeing fairly stable NAVs over Q4. This would make sense as corporate credit spreads narrowed over Q4. While the macro picture is slowing it's not exactly falling off a cliff. On the net income side, numbers are coming in with double-digit jumps. Q4 is likely to see the largest jump in net income for BDCs over this Fed hiking period given the path of Libor over 2022. This, along with stable portfolio quality, is why we expect another wave of dividend hikes in the sector. All in all, it's pretty close to as good as it gets for the sector.

Market Commentary

Gladstone Capital ( GLAD ) raised the dividend by 7%. This is the third consecutive quarterly dividend raise for a total rise of 15% since the start of last year. We should see more hikes to come as short-term rates continue to filter through to income over the next 3-6 months. GLAD continues to trade at an elevated valuation.

BDC Tool Update

We are not fans of a "head-to-head" kind of analysis a la "which is the better BDC: CSWC or ARCC". Whenever we see this type of analysis we wonder whether they are going to do all the other 2,000 or so permutations in the sector.

That said, there are cases when it's useful to line up two BDCs together and compare them across various metrics. This is particularly true when considering a rotation between one BDC (say, one that has gotten expensive) and another potential holding.

To this effect, we added a feature to the BDC Tool that lets users compare two BDCs along various dimensions both in terms of current metrics as well as historic time series such as valuations.

Stance and Takeaways

We continue to be upbeat about the BDC sector, particularly with the earnings season coming up shortly, which we expect to see dividend hikes and stable NAVs. At the same time, valuations are no longer cheap - the average BDC is 18% off its low over the past year. For this reason, we expect to downscale our BDC exposure on any strong pops, moving to lower beta alternatives like BDC bonds which have a more favorable downside profile.

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