PNNT - PennantPark: Buying Undervalued Assets In An Overvalued Debt Market

2023-08-08 06:56:33 ET

Summary

• Business Development Companies, such as PennantPark, are benefiting from the regulatory strains on traditional banks, creating opportunities in the corporate lending market.
• Banks are reducing exposure to commercial loans and securities, potentially benefiting non-bank lenders.
• PennantPark's increased leverage makes it more exposed to a negative credit cycle or recession than ever before.
• While PennantPark has an excellent track record, the corporate debt market appears systematically overvalued due to excessive demand from income-driven investors.

Over recent months, various strains in the banking system and the economy have led to headwinds for the corporate lending market. Banks have sharply increased lending standards to reduce exposure to a potential reversal of the credit cycle. At the same time, tightening lending standards have increased opportunities for non-bank lenders that can fill the gaps created by banks. Accordingly, Business Development Companies, such as those in the ETF ( BIZD ) and the popular PennantPark ( PNNT ), have risen sharply in value while regional banks ( KRE ) have deteriorated. See below:

BDCs, such as PennantPark, are particularly interesting investments today because they benefit from traditional banking system regulatory strains. To a significant extent, banks cannot make the "best" reward-for-risk investments because they're subject to the Basel Regulatory Framework, which overweights riskier corporate loan assets while underweighting sovereign bond securities. As a result, most large banks have increased securities ownership while decreasing commercial loans (as a percent of deposits) over the past decade. See below:

Banks are reluctant to issue commercial and industrial loans, particularly since the 2020 strains. Banks have also reduced exposure to securities after suffering tremendous off-balance sheet losses on those assets last year (creating bank failures this year). Banks will likely continue to face deposit outflows due to the ongoing reduction to the Monetary Base (i.e., Federal Reserve asset reduction) combined with higher interest rates. As such, I expect we will continue to see banks looking to reduce exposure to the corporate lending market, creating potential benefits for non-bank lenders.

I believe these more significant financial market trends are substantial for Business Development Companies because they absorb most of the risk banks are avoiding or reducing. For companies like PennantPark, this increases the available supply of loans and may likely increase the borrowing spreads on those loans. Of course, as banks avoid the market and interest rates rise, it is possible that financing and economic issues will spill over and cause a sharp increase in loan losses. Like most BDCs, PennantPark operates at much higher leverage today than it used to, so its exposure to an adverse credit event or cycle could be more considerable than most investors expect.

Risks and Rewards in PennantPark

PennantPark's PNNT invests primarily in middle-market senior secured loans in various economic sectors. Roughly 55% of its assets are first-lien loans, with the rest a mixture of second-lien (11%), subordinated (13%), and equity (21%). In total, two-thirds of its assets are secured, meaning it is undoubtedly lending into a higher-risk tier. Its lending industries are highly diversified across 32 industries, with Business Services commanding the highest allocation at 19% and all others below 10%. Since it carries no strong industry bias, its most significant risks are related to the trend in both the manufacturing and services economies.

The company aims to invest in loans at a spread of +5.5% to +10.5%, with most being toward the lower end of that range as first-lien loans. Most of its borrowers should be at a similar credit risk to the more speculative B-rated and below corporate assets at those yields. However, while that segment of the credit market will drive the fair-value yield on PNNT's assets, the company's success hinges on the fact that the core Middle Market loan class has a substantially lower loss rate of 1.1% compared to 7.3% for High Yield Bonds . Further, the company states its average loss ratio is just 21 basis points, implying it is lending in very low-risk assets that still carry a similar yield to junk bonds.

There can be a few reasons for this discrepancy. For one, PennantPark believes that the Middle Market segment offers a systemically superior reward-for-risk tradeoff than others, potentially because most large banks will overlook companies in that $10-$50M EBITDA range. In general, such loans are too small for banks to give significant attention to but too large for small business lending (which has primarily automated underwriting); thus, PNNT can cater to that unique underserved market niche. Further, the company uses in-depth underwriting to allocate toward companies with stronger moats. To a large extent, Middle Market companies have naturally strong moats because they often have a regional or niche focus (for example, a regional accounting firm or a niche Dominion Voting systems - a borrower of PNNT).

Of course, while PNNT certainly has a niche competitive benefit, its historical loan losses may be low simply because it was not a large lender during the last recessions. Additionally, although PNNT may have a reward-for-risk advantage due to a lack of traditional bank activity in the Middle Market segment, these loans are far more illiquid and are generally "buy to hold" loans. As banks and companies face liquidity issues due to the falling monetary base, Pennant may eventually face greater liquidity pressures.

Crucially, PNNT's debt-to-equity ratio ended at 1.45X last quarter, up from just 0.84X in Q2 2022, indicating a sharp increase in risk-taking activity. Further, before 2018, BDCs could not lend at a debt-to-equity ratio over 1X, now 2X . This change was made to increase lending activity in under-appreciated markets, but it also systemically increases the risk for PNNT. The company was slow to increase leverage accordingly but has been more aggressive over the past year. I believe increased lending from BDCs may push corporate debt yields down during an otherwise risky economic period. Should PNNT face losses on some of its loans, particularly its unsecured loans, it could fail as it cannot sell its other loans due to its illiquid nature and higher leverage.

Looking more broadly at the corporate lending market, there has been an apparent improvement in lending since 2023 began. Yield spreads on B to CCC loans (which drive PNNT's asset values) have declined by around 2-3% since the 2022 peak. Base interest rates have risen over this period, so these loans' total interest rate has likely grown. However, because PNNT is both borrowing and lending at variable rates, its yield and NAV are driven by the spreads on these assets. Generally, higher corporate debt spreads will increase PNNT's yield but decrease its net asset value. See below:

The sharp increase in PNNT's value over recent months is likely associated with the notable decline in corporate credit spreads, improving the fair value of many of PNNT's assets. Corporate credit spreads are strongly associated with the VIX index despite being based on entirely different asset classes. An increase or decrease in the stock market's volatility outlook drives changes in lending risk, so the recent decline in corporate credit spreads may be due to the abnormally low VIX index level.

Notably, the VIX has spiked over the past week due to increased market turbulence, potentially indicating a rebound in corporate credit spreads that could impair PNNT's value. To a large degree, I believe the VIX index and corporate credit spreads are far too low given economic fundamentals, and are abnormally low due to increased risk tolerance from investors (specifically, irrational exuberance surrounding high dividend investments ). Typically, a strong negative correlation exists between credit spreads and manufacturing and services PMIs, which are historically accurate leading GDP indicators. When the PMI is low, and businesses see activity decline, credit spreads increase on higher loan loss risk, and vice versa. However, today the PMIs are very low, and credit spreads are low, indicating a potential systemic undervaluation of risk. See below:

A similar abnormal pattern was seen in late 2019 when the PMIs indicated a recession (the yield curve was also inverted), and credit spreads were very low. It was my view then , as it is now, that the market is systematically underestimating risk in higher-yield assets, likely due to excessive investment demand from income-driven retired investors. Since so many US investors are in or around retirement ages (and probably most readers) and may not have sufficient saved capital, many have flocked toward riskier asset classes (like PNNT) than were typically seen in prior generations. While that factor is not directly relevant for PNNT, it is important because it seems to lead to widespread underestimation of risk in high-yield assets, potentially leading to significant losses.

In 2019 I expected this risk to surface in 2020, encouraging investors to diversify income-investing approaches heavily. To an extent, this risk did surface in 2020, but it was heavily overshadowed by the more significant economic impacts of COVID lockdowns and, more importantly, the extreme stimulus created through 2021. Now that the 2020-2022 credit cycle has gone "full circle," the market mirrors the late 2019 position, as seen in the vast disconnect between the "strong" VIX/Credit spreads vs. the bearish economic trend (PMI, yield curve, etc.).

In my view, PNNT's reward-for-risk outlook is very mixed. On the one hand, the company benefits from investing in loans that appear to pay abnormally high yields compared to their historical loan loss rate; thus, its assets are potentially undervalued compared to most corporate debt. On the other hand, the corporate lending market appears to be overvalued, with credit spreads appearing far too low in light of the recessionary manufacturing outlook and stagnation in the services sector. The services PMI remains much stronger than the manufacturing PMI. While PennantPark owns manufacturing and services loans, it is more weighted toward the services sectors, so its debt may carry less immediate recessionary risks than most. In my view, an adverse action in the credit market, combined with PNNT's significantly increased leverage ratio, is likely enough to push the company lower over the coming year.

The Bottom Line

I am moderately bearish on PNNT and believe it will likely lose most of its recent gains. The company rose in value recently due to a sharp decline in corporate debt credit spreads, driven by an abnormally low VIX and a potential systemic underestimation of market risk. While PNNT may be trading close to its NAV, I believe its NAV may soon decline sharply as the entire corporate debt market braces for a slowdown. Since PNNT's leverage is much higher today than in recent years, its exposure to a decline in asset values is much higher. Further, a sufficiently significant reduction in its asset value could be catastrophic for PNNT since the Middle Market is increasingly illiquid as traditional banks further decrease corporate lending.

PNNT's historically solid track record of picking low loan loss assets that still pay high yields substantially offset these risks. It is also offset by the fact that many of the company's PNNTs tend to face systemically lower competitive and macroeconomic risks than most (mainly manufacturing today). To a large extent, I believe the macroeconomic risks facing PNNT are offset by the company's record of alpha generation. However, in light of its increased leverage, PNNT's overall risk remains quite large, although not as large as that of most BDCs and traditional regional banks. I suspect PNNT should decline over the coming year, I expect it to outperform its broader peer group, and I do not believe it is overvalued today on a NAV basis. Thus, while I am slightly bearish on PNNT, I would indeed not short the stock because it could perform quite well if a recession fails to occur over the coming year.

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