TRIN - BDC Weekly Review: Why Analysts Were Pessimistic About Net Income Performance

2023-03-11 03:50:10 ET

Summary

• We take a look at the action in business development companies through the first week of March and highlight some of the key themes we are watching.
• BDCs were flat during the week, taking a breather from the recent strong run.
• We take a look at why analysts were overly pessimistic about Q3 and Q4 net income performance across the sector.
• And highlight a couple of earnings releases.

This article was first released to Systematic Income subscribers and free trials on Mar. 3.

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 first 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. 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 flat on the week, taking a pause from a strong recent run. Year-to-date, the sector remains the best performer across the income space, supported by continued dividend hikes and stable portfolio quality.

The total return index is flat from the start of 2022 - a welcome result for investors, particularly for those who took advantage of a number of drawdowns in 2022 to add holdings.

Average BDC valuation remains around 100%, not far from its historic average. This leaves a smaller margin of safety for investors, particularly as net income increases are likely to slow down over the coming quarters given the leveling off in short-term rates.

Market Themes

Investors who have paid attention to BDC Q3 and Q4 earnings releases likely noticed the amount of net income beats which seem to be there for just about every company. What's driving such good net income numbers and why were analysts so pessimistic?

Apart from a likely conservative stance by analysts (who don't want to look like overly bullish cheerleaders), the key reason for such pessimism on net income is that, in the last hiking cycle, net income (or core ROE in the chart below) actually fell as this chart shows.

However, as we discussed in September, there are significant differences between today's hiking cycle and the previous one.

First, the rise in base rates has been significantly higher and steeper this cycle than it was in the previous one. Short-term rates have already risen by over 4.5% (and are expected to keep rising) versus around 2% in the last cycle.

Two, we are going through a more mild default environment as the following chart shows. This keeps portfolios values and income levels higher.

Three, many BDCs were able to lock in ultra-low bond yields over 2021, further boosting net income levels.

As we have highlighted a number of times, the current environment is pretty much as good as it gets for BDCs. That said, we don't expect the kinds of net income gains we have seen over the last couple of quarters to last past Q2 given the slowing in short-term rates as the Fed is approaching what is likely to be its terminal policy rate. This means we are also less likely to see the strong pace of dividend hikes across the sector and this will remove an important price support mechanism. As we highlight below, this development alongside fairly high valuations means we are turning more cautious on the sector.

Market Commentary

Trinity Capital ( TRIN ) saw a 4.2% NAV drop in Q4 largely due to further writedowns in Femtech and bitcoin miner Core Scientific. From the looks of it, this (and more) was entirely priced in as the stock rallied strongly on the news, leaving its 104% valuation 5% above the sector average. Net income rose by 10% for coverage of slightly above 100%.

The price of bitcoin has risen sharply since the start of the year so that has supported its other miner positions. Given the company’s recent NAV trajectory, there is now a kind of negative margin of safety in the stock. It’s likely the market thinks the miner positions are going to get written back up given what’s happened to bitcoin and that could very well be the case however that’s a fairly speculative bet since this element very much depends on the price of bitcoin.

Blackstone Secured Lending ( BXSL ) reported Q4 results. The company hiked the dividend by 17% to $0.70. Recall the company stopped paying the specials which were there to support the stock during the lock-up expiries. That opened up a wide gap between net income and the base dividend, particularly in a period of sharply rising net income (BXSL has a high net income beta relative to the sector, owing to an above average level of floating-rate assets, below-average level of floating-rate debt and above-average leverage).

All this meant that a large dividend hike was on the cards as discussed in our previous article on the stock. However, even with the dividend hike, coverage remains very high while net income continues to increase. Non-accruals remained at zero and the NAV rose by a bit less than 1% percent. Hard to ask for anything better.

Stance and Takeaways

Our recent focus in the sector has been two-fold. One was to upgrade our allocations towards higher-quality, upper middle-market sub-sector and more diversified BDCs such as BXSL, ARCC and OCSL. And the other was to start to marginally unwind our allocation to the sector, reducing a position that was increased over 2022 in favor of more resilient securities such as BDC baby bonds. A reduced margin of safety makes it less compelling to reach for yield in higher-beta securities like BDC common shares, particularly at this stage of the macro cycle.

For further details see: