CSWC - Don't Give Up On BDCs In 2024

2023-12-27 09:00:00 ET

Summary

• Business Development Companies are great long-term investments, not just for high-interest rate environments.
• BDCs have benefited from the banking crisis and tightened lending standards, providing them with opportunities for long-term lending.
• BDCs are expected to continue performing well even as interest rates decline, with potential for extra income and special dividends for shareholders.
• BDCs like Main Street Capital, Ares Capital, and Capital Southwest performed well before interest rates surged, and I expect them to continue for the foreseeable future.
• Investors who've accumulated a large number of shares in the sector may experience some capital losses once rates decline.

Introduction

As an income investor, Business Development Companies have been an essential part of my portfolio. There are many high-quality ones to choose from in the sector ( BIZD ), but there are a few that stand out to me, and most of them I currently hold. Ares Capital ( ARCC ), Capital Southwest ( CSWC ), and fairly newcomer Blackstone Secured Lending ( BXSL ) are among my favorites. Two I own in my taxable account and the other I hold in my Roth IRA. I've been asked by readers how BDCs have done in the lower rate environment. Just to be clear, I have a long-term outlook for all my holdings.

I've been there and done that with trading in & out of stocks and let me say it's exhausting. It's emotionally taxing. That's one of the reasons I switched to dividend investing. Get paid from companies with high-quality business models either every month or quarter. In this article, I wanted to do something a little different. Instead of picking a company and giving my thoughts on it, I wanted to give investors a little insight on BDCs and why I think they are holdings for more than just for a high-interest rate environment.

BDCs Are Great Long-Term Investments Too

I'm sure most readers know the backstory on Business Development Companies. They were created in 1980 by Congress to fuel job growth and help emerging or new businesses raise capital. Many of these are publicly traded on the stock market and they invest in smaller, startup companies by providing funding. Because of this they are often considered risky and not investments for the long-term. Similar to REITs they too must pay out most of their income in the form of dividends to enjoy their tax advantages.

If you remember back in March, we experienced a banking crisis with the fallout of a few banks. For those who held them in their portfolios, you probably weren't too happy about the losses you experienced during that time. And although some have recovered their losses, there are banks yet to return to their prices before that time period. Will they ever recover? I can't answer that but I'm sure the high-quality ones that haven't will eventually.

I bring this up because even though the banking sector may be forever changed, or at least for the foreseeable future, this was something good for BDCs. As bank lending standards tightened, this gave BDCs a great opportunity for lending over the longer-term.

Here is what Main Street Capital's ( MAIN ) CEO said earlier this year:

BDCs have the flexibility to make investments that may be difficult for traditional banks to execute due to their leveraged lending limits and other restrictions they have to comply with in their lending practices. As banks continue to pull back from middle-market it increases the BDC industry's opportunity to provide the same types of debt financing historically provided by traditional commercial banks.

Is the banking lending landscape forever changed? Again, no one knows but I think the higher-quality BDCs will stand to benefit from this for a long time. So even when rates decline these companies will continue to do well.

Below is a question from a reader recently:

What's your experience with ARCC or other BDCs in the lower rate environment such as 2020-2022? Assuming lower prices and loss of capital, but yields remaining high...I am retired and have built 60% to 70% of my portfolio in individual corporate bonds, state housing bonds, and municipal bonds. Building BDC positions over the last 3 months.

My answer to that question is that BDCs performed well in the lower interest rate environment and I think in 2024 when rates start to decline they will continue to do so. Why? Because the high-quality ones that were performing well before still have the same management teams, and many have strengthened their portfolios even further. Many have been and continue to do this by playing defense and moving into first-lien loans.

This gives them a lower chance of loan defaults/non-accruals. Many have seen a rise in these because of the higher rate environment. But what about when things get back to normal? I know someone might say, "We will never get back to a near zero interest rate environment again." That may be true but rates won't stay here forever.

When rates do start to decline, here's what I think will happen. Many BDCs will still perform well in 2024, even continuing to pay out specials and supplementals. Interest rates will decline gradually, not rapidly like how they were raised. So, BDCs will still enjoy the extra income they saw in 2022 and 2023. If you're invested in ARCC or have been for some time then you know they like to rollover their extra income into the new year. At the end of 2022 the BDC had $643 million in extra income that they rolled over in 2023.

And I'm expecting something similar going into 2024. So, even with rates declining they will likely have extra income to reward shareholders, on top of the income they earn during the year. And with them being required by law to pay out 90% of this, where do you think it's going to go? Most likely to shareholders. This may be in the form of a mid-year special or end of year special. If you've been a long-time holder of CSWC then you may be familiar with the end-of-year specials the company paid out in 2018, 2019, and 2021.

If the company hadn't been performing well those years then it's likely they wouldn't have paid out special dividends. So, BDCs are not just for high-interest rate environments. I remember being on the receiving end of year special from CSWC, and thinking to myself "Just in time for Christmas!"

Here is how MAIN, ARCC, & CSWC did against the S&P ( SPY ) in total returns from April 2020 (right after the flash crash) until March of 2022 (right before interest rate hikes).

Here is how they did in price returns over the same period.

Here is how they did from January 1st, 2015 to January 1st, 2020 against SPY in total returns.

Here's how they did during the same period in price return. Each BDC outperformed with the exception of ARCC. Still think they are short-term investments? I don't.

What Will Happen To Their Price When Rates Decline?

When rates do start to fall I suspect BDC prices will decline also. Gradually. As an investor in the sector for years now some typically trade in a tight range. ARCC usually trades between $16-$18. CSWC usually trades in a similar, slightly higher range. I haven't added to any of my BDC positions due to the macro environment causing the price appreciation many have experienced. So, if you're new to investing in the sector and have been adding recently, it's likely you may see some capital losses in the near to medium term. It's ok! Because these are not just short-term investments. What you should do is continue to average down to build your income stream up. Unless the fundamentals change in your holdings, continue to build that dividend snowball. Some BDCs may go back to their prior ranges before the start of rate hikes and some may not. But I still think they will continue to outperform the broader market as before.

Closing Thoughts

So, in closing thoughts here are a couple of questions you should to ask yourself.

Did you increase your net worth?

Did you position yourself closer to achieve financial freedom?

I don't know what 2024 will bring but hopefully it's great things, especially for us dividend investors. All we can do is prepare for the worst but expect the best. But I think the new year is going to be great for the market. Remember there were investors that sat around waiting for an apocalypse to happen that never came. If you were one of them, then you missed out on increasing your net worth and moving one step closer to financial freedom. Bear markets are typically followed by Bull ones. But no matter what happens you should continue to dollar-cost average into your holdings.

My goal on Seeking Alpha is to not only introduce you to new stocks/investments, but to also give you a new perspective on investing. And hopefully I've done that.

I'll leave you all with this quote from Warren Buffett:

Cash is always a bad investment. When people say cash is king, that's crazy. Cash wasn't producing anything and it's sure to go down in value over time. I would much rather have good businesses than cash.

Disclaimer: Opinions expressed by the author are not investment advice or recommendations. Any information in this article is for entertainment purposes only. Before making any investment decisions, investors should do their own due diligence and consult with a certified financial advisor.

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