PNNT - BDC Weekly Review: Fees - A Potential Hedge For Lower Interest Income

2023-05-27 03:51:55 ET

Summary

• We take a look at the action in business development companies through the third week of May and highlight some of the key themes we are watching.
• BDCs had a good week with a 2.5% total return. A rise in net income over Q1 has supported the sector in a difficult market.
• Higher fee income could act as a potential hedge for lower interest income once the Fed starts to cut rates, at least in one scenario.
• We highlight BXSL results, which continues to outperform the sector.

This article was first released to Systematic Income subscribers and free trials on May 20.

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 May.

Market Action

The BDC sector had a good week with a 2.5% return, outperforming the broader income space. Every BDC whose Q1 numbers we have processed so far has put up a positive total NAV return for the quarter, which has supported valuations.

A couple of underperformers, [[PNNT]] and [[BBDC]] caught a strong bid this week. Both companies have a relatively high equity / warrant allocation, which has proven to be a headwind for performance.

At this point we would prefer BBDC over PNNT for bottom fishers as its recent performance has stabilized and the 22% discount to the sector average valuation contains a decent margin of safety.

Market Themes

BDCs have performed very well since the start of the current upward rate cycle, which has put a dent in many income sectors. Net income has risen by double-digit levels, while NAVs have been relatively stable and non-accruals edged up only marginally.

However, one worry that many BDC investors share is what will happen once short-term rates start to reverse. The market expects short-term rates to move from around 5% towards 3% over the next couple of years. Just like rising short-term rates boosted interest income, falling short-term rates will mechanically reduce interest income.

In order to gauge how things will play out, however, we need to consider at least two different scenarios in which short-term rates fall. One is the scenario where the Fed cut rates because the macro picture is bad enough to warrant it. The second scenario is where the macro picture is OK, but disinflation happens quickly enough to give Fed enough confidence to cut rates.

In the former "bad macro" scenario, we can expect interest income to fall with short-term rates. The rise in non-accruals in this scenario will likely push investment income even lower than predicted by rates.

In the latter "OK macro" scenario interest income will mechanically fall as well, however, it could very well be offset by fee income from loan prepayments on the back of deal-making "exits" such as IPOs and M&A.

The chart below breaks [[ARCC]] investment income down. We can see that in 2021 fee income was a significant part of the company's total income and nearly a third of its interest income. As deal-making risk appetite cooled off in 2022, fee income fell off substantially.

If short-term rates fall but risk appetite comes back, fee income could mostly or partly offset the drop in interest income, at least across those firms with larger venture debt holdings. In this sense, fee income could work as a partial hedge for falling interest income.

A couple of BDCs which could see a significant boost in fee income are ARCC and [[TSLX]], both which we currently hold in our High-Income Portfolio.

Market Commentary

Blackstone Secured Lending Fund (BXSL) reported very good Q1 results. Total NAV return for the quarter was +3.4%, beating the sector. Net income increased by 3%. The dividend was kept the same, which we didn’t expect since dividend coverage is now a bizarre 133%. That kind of retained income does have a purpose, as it allows the company to put the cash into new, higher-yielding loans, creating additional opportunities for compounding returns.

Our allocation to BXSL was recently downsized given its valuation moved out to trade 7-10% above the sector average level. Previously, the stock dipped repeatedly towards the sector average valuation, at which point it was a no-brainer Buy . Currently, it’s fairly valued and hopefully it moves back towards cheaper territory.

Stance and Takeaways

The median BDC increase in net income over Q1 was close to 4% which has supported BDC valuations over a relatively difficult stretch. We expect another net income bump over Q2, though it should be a modest, low single-digit affair. So far, the sector is priced for a modest recession, which presents potential upside in a soft-landing scenario.

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