HRZN - Horizon Technology Finance: A 10.3% Dividend Yield Paid Monthly As The Market Fights The Fed

2023-12-12 12:18:06 ET

Summary

• HRZN is outearning its dividend by 160% and currently yields 10.3%.
• 2024 is set to be a crucial year for the Fed's fight against inflation, with the market expecting rate cuts as early as May.
• Leverage and NAV will drive value creation for the next year as HRZN sees a rise in loans on non-accrual status but no changes to its credit quality ratings.

2024 is set to become an inflection point in the Fed's fight against inflation. The stakes are high and the market has called the bluff of higher for longer rhetoric to price in rate cuts as early as the May 2024 FOMC meeting. For BDCs like Horizon Technology Finance (HRZN), rates at 22-year highs have formed an incredible tailwind to its debt portfolio yield which stood at 17.1% at the end of its fiscal 2023 third quarter. HRZN provides structured debt products to life science and technology companies. This debt typically comes with terms of 3-5 years and with higher rates due to the elevated credit risk profile of the borrowers. For example, HRZN originated a $15 million venture loan in August to Tallac Therapeutics, a Bay Area-based biopharmaceutical startup founded in 2018 to develop multiple novel immunotherapies to fight cancer. Income wrapped around gradual net asset value growth is the prize and HRZN last declared a $0.11 per share monthly cash dividend for a 10.3% annualized forward yield.

30-Day Fed Funds futures pricing data as visualized by the CME FedWatch Tool currently has a 50 basis point cut to the Fed funds rate in the first half of next year as the base case, at odds with the median Fed estimates that interest rates would only sit at 5.1% at the end of 2024. Against this new zeitgeist, leverage, underwriting quality, and NAV become the arbiters of value creation. Assuming flat NAV growth with a 10% return per year driven by the dividend, an investment in HRZN over five years could produce a nearly 1.7x return on invested capital. However, the BDC's NAV on a diluted per share basis has continued to trend lower since I last covered it.

Leverage And Underwriting Quality

HRZN's debt-to-equity ratio sat at 1.26x as of the end of the third quarter, higher than most of its venture debt BDC peers but still within a comfortable level. Leverage is great for boosting returns but amplifies downside volatility during periods of more material economic disruption. HRZN's ratio has been trending upwards, sitting just below 1x at the start of 2022. High leverage when paired with a deterioration in underwriting quality is the specter set to haunt BDCs in 2024. HRZN had three investments on nonaccrual status with a cost of $43.6 million and a fair value of $17.2 million at the end of the third quarter, this formed 5.78% and 2.36% respectively of its investment portfolio. This portfolio was $729.1 million at fair value and $754.8 million at cost.

HRZN describes non-accruals as investments that are at least 90 days past due or events where it does not expect to receive interest and principal repayments. Critically, the third quarter represented a deterioration from the end of 2022 which had 2.90% of its loans on non-accruals at cost and 1.15% at fair value. Debt investment asset quality did see quite substantial changes with debt investments rated 2 and 1, the lowest credit quality rating tiers, at 13.5% at the end of the third quarter. This was up from 5.1% at the end of 2022, a 2.6x increase in nine months. However, debt investments had a weighted average credit rating of 3.1 at the end of the third quarter, unchanged from the end of 2022 with an increase in debt rated 4 to 22.2% from 13.7%.

Investment Income, NAV, And Spillover Income

HRZN recorded a third-quarter total investment income of $29.1 million , up 25.3% versus its year-ago comp with the rise in debt yield and the growth of its portfolio driving the gains. The portfolio at fair value grew by 15% over its year-ago comp with the dollar-weighted annualized yield on average debt investments at the end of the third quarter of 17.1% up 120 basis points versus 15.9% in the year-ago period. The BDC funded eight loans totaling $88.4 million during the third quarter, offset by $47 million in repayments, refinancings, and partial paydowns. NAV at $346.57 million was up 12.6% from its year-ago comp but was down $9 million sequentially. However, NAV on a diluted per share basis has declined for five consecutive quarters. This was $10.41 per share at the end of the third quarter, down $1.25 from $11.66 per share in the year-ago quarter.

Most BDCs issue new equity and have leaned on this more heavily in recent years for funding with interest rates sitting at highs. However, HRZN has perhaps gone too heavy with its weighted average shares outstanding of 32,451,900 at the end of the third quarter up 26% year-over-year and by 181% over the last five years. Whilst this would have been accretive as they were issued with the stock trading above NAV, the continued decline in NAV per share and the increase of leverage despite the issue of new shares means the BDC is less of a compelling buy. Net investment income was $0.53 per share, enough to cover a quarter of the dividend by 160%. Outearning the dividend meant an undistributed spillover income of $1.23 per share at the end of the third quarter and an additional special dividend of $0.05 per share paid out in December. The fully covered dividend set against the growing portfolio means HRZN is a hold.

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