Summary
- We take a look at the action in business development companies through the fourth week of January and highlight some of the key themes we are watching.
- BDCs had another good week with the sector approaching a double-digit return this year already.
- We take another look at FGB - a CEF that allocates primarily to BDCs to see how it has performed over 2022.
- And highlight a couple of corporate events from OCSL and PFLT.
- In light of its strong rally, we took down our TRIN allocation to zero, replacing it with a Saratoga baby bond.
This article was first released to Systematic Income subscribers and free trials on Jan. 28 .
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 fourth week of January.
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 had another strong week with a total return of around 1.5%. Two of the three underperforming BDCs had corporate events - with PennantPark Floating Rate Capital ( PFLT ) having a public offering which took its stock down around 10% while the Oaktree Specialty Lending Corporation ( OCSL ) had a reverse split, which many investors don't like for some reason. Trinity Capital ( TRIN ) remains the outperformer. As we discuss below, we took down our allocation to zero on the back of this strength as it leaves little margin of safety.
January has been a great month for the sector with one of the strongest performances over the last couple of years.
Systematic Income
The sector has almost fully reversed the 2022 drawdown and is trading nearly flat to its 2022 level in total return terms.
Systematic Income
The average sector valuation of 97% is only slightly below its historic average.
Systematic Income
Market Themes
This week we check up on the First Trust Specialty Finance&Financial Opportunities Fund ( FGB ) which is a CEF that allocates primarily to BDCs. In theory, FGB should be a great vehicle to hold BDCs. It benefits from active management, additional leverage and it trades at a discount which magnifies the underlying yield of the portfolio.
However, a look at the long-term performance of the FGB total NAV return shows that it has managed to put in next to worst performance relative to all the BDCs in our coverage that have 5-year total returns as well as the two BDC ETFs. As a technical sidenote, to compare performance on an apples-to-apples basis we need to look at the FGB total NAV returns versus individual BDC price returns because the NAV returns of FGB is driven by BDC prices whereas the FGB price is also driven by changes in the discount of FGB as well.
Over 2022, FGB underperformed once again and this year it is lagging as well.
What is going on here?
Readers who are familiar with our CEF analysis may already know that we have a bias against owning equities or other relatively volatile assets in a leveraged CEF format for a few reasons. First, CEFs aren't great vehicles for these more volatile assets (e.g. CLO Equity, MLPs, stocks etc.) because of their leverage constraints.
BDCs tend to be more volatile than credit assets. Such a high level of volatility and drawdowns is more likely to drive deleveraging in leveraged CEFs. The fund's shareholder reports clearly show how the fund deleveraged a number of times, locking in economic losses for investors. This is not the only reason for its underperformance but it is an important one.
The other reason we tend to avoid equity-focused CEFs is that, for the majority of equity CEFs, active management doesn't really seem to work, even outside of the deleveraging issue (most equity CEFs are not leveraged). We have shown several times that most equity CEFs tend to underperform the broad (or the relevant sector) equity indices.
If we put the performance issue aside for the moment, some investors may be attracted to a CEF like FGB because it trades at a discount - about 12% currently - with the view that they can own a bunch of BDCs (that they would otherwise hold anyway) at a discount to their market price. In other words, you can pay 100% for something or 88% for the same thing - why wouldn't you take the 12% discount offered by the CEF since it seems like a free lunch.
It is important to stress, however, that there is no free lunch here. FGB charges investors 1% in management fees (and a bit more in fund expenses) so it should trade at a discount that reflects its fee. As it happens, with BDC yields of around 11%, the fund should trade at least at a 9% discount (in order to compensate for 1/11th of its yield going to the manager rather than the investors).
All in all, FGB remains a consistently poor way to allocate to the sector - a function of its structure as well as its management.
Market Commentary
OCSL had two pieces of news. First was its 1:3 reverse split. The stock has been weak after the news - possibly because some brokers charge fees for reverse splits which holders, understandably, don't want to wear. It also completed its merger with its private sister BDC OSI II. The new BDC will be composed of 80% OCSL assets. As a sweetener, a portion of management fees will be waived for two years for a total of $9m. This is about the equivalent of one-quarter base management fee for the old OCSL. The stock has come off nicely with the recently discussed ARCC/OCSL switch now in the money by close to 10%.
PFLT ran a public offering at $11.20 or roughly in line with its expected NAV as of Q4. Interestingly, given the sharp rally in publicly traded assets since the start of the year, a marked-to-market NAV would come in above the offering price, resulting in a small NAV dilution. However, since BDC assets aren't marked to market, the official line is that there is no dilution. PFLT has been trading at an elevated valuation, above the sector average despite pretty poor historic returns, making it one of the outliers in the sector. Its 5Y total NAV return is not far from half the sector average so it's puzzling why it has traded so rich. It is now down to a 93% valuation which is slightly below the median and remains rich.
Stance and Takeaways
With TRIN now trading above the sector average valuation and very close to its NAV, it leaves no margin of safety and the 1% High Income position was rotated to BDC Saratoga baby bond ( SAY ) that was trading at an 8.2% yield, before its rally to a 7.95% yield. If BDCs continue to trade higher, it will begin to make sense for investors to derisk somewhat by rotating to BDC baby bonds which remained mostly resilient last year with a total return of around -1% on average.
For further details see:
BDC Weekly Review: Another Year Of Underperformance For BDC CEF FGB