2023-04-16 04:42:06 ET
Summary
- Despite the risk of a banking crisis and a worsening financial situation, BDCs appear to be well-positioned to maintain their investment income and dividend growth trend.
- Indeed, the banking crisis is likely to create new and appealing investment opportunities for direct lenders like business development companies.
- VanEck BDC Income ETF is one of the best options in the business development space due to its high yield and high concentration on top-rated companies.
The banking crisis and deteriorating financial situation have increased the risk in the financial sector, but it is likely that the business development industry will continue to benefit from the situation. Because of their strict underwriting standards and portfolio management strategies, business development firms have a low risk of credit losses. In 2023, the high demand for direct lending and floating nature investment portfolios would help BDCs generate record investment income and dividends. Fortunately, a large number of stocks and ETFs like VanEck BDC Income ETF ( BIZD ) are still trading at a significant discount with a robust financial growth outlook.
Banking Crisis is a Tailwind for BDCs
"The significant amount of volatility in the capital markets has brought more favorable competitive dynamics, and we are seeing a significantly more appealing risk-reward market environment," Ares Capital CEO Kipp deVeer said .
Many CEOs of business development companies made similar remarks during the conference calls for the fourth quarter. These claims are difficult to dispute because record 2022 financial results , portfolio growth, and low non-accruals strongly imply that direct lending has been significantly outpacing syndicated markets in difficult times. In 2023, the failure of a number of regional banks, who were among the largest lenders to startups and middle markets, forced the entire banking sector to focus on increasing liquidity and reducing lending. Consequently, lower and middle-market companies will increasingly turn to alternative financing sources like business development firms. As of the end of the third quarter of 2022, BDCs’ assets under management stood around $270 billion, and forecasts hint that assets could easily top the $300 billion level in 2023.
Low Risk of Portfolio Losses
While regional banks and other financial institutions face a risk of significant credit losses , the underwriting policies of business development companies appear to be robust enough to mitigate contagion risk. This is evident from the low non-accrual rate , which in 2022 averaged just 1% of all debt investments at fair value.
Middle Market Vs Syndicated (Fidus Capital Presentation)
Another factor contributing to lower non-accruals is the fact that BDCs offer loans to middle and lower-middle market businesses, which historically have higher growth rates, lower default rates, and higher recovery rates than businesses with large market caps. In fact, businesses with an EBITDA under $20 million actually offer safer returns than advanced-stage companies. Fidus Investment (FDUS), for example, which targets lower middle market companies with annual EBITDA of $5 to $30 million, had non-accruals of less than 1% of its total portfolio on a fair value basis.
BDC Portfolio by Security Type (refinitiv.com)
Aside from the low non-accrual rate, data shows that around 90% of BDC portfolio loans are floating rate first and second liens. This means that BDC loans are collateralized, and their strategy of offering floating rates on lending while receiving fixed rates on loan liabilities will benefit greatly from the Fed's rate hike policy. As a result, we can expect net investment income yields and dividend metrics to improve in 2023. Overall, it seems that BDCs are not only well-positioned to face challenges head-on but are also likely to profit from traditional banks' tight lending standards and higher interest rates.
VanEck BDC Income ETF’s Outlook
BIZD Stock Holdings (Seeking Alpha)
Despite the positive outlook for the business development sector, selecting the right stock or ETF can help investors achieve higher risk-adjusted returns. There are currently many companies in the industry that offer high single-digit to double-digit dividend yields, as well as consistent share price growth. However, it might be a good idea to choose an ETF to reduce the risks associated with a single-stock investment. VanEck BDC Income is one of the best ETFs in the business development space due to its broad industry coverage. It could be a good investment in 2023 for a variety of reasons, including a double-digit dividend yield and a high concentration on top-tier business development companies. Its top ten holdings account for 75% of the portfolio.
Ares Capital ( ARCC ), BIZD's largest stock holding, appears to be well-positioned to boost cash returns for investors in 2023. The company's fourth-quarter core EPS of $0.63 topped the analyst consensus of $0.56. In 2023, the company's earnings growth is anticipated to pick up due to its floating nature investment portfolio. According to market analysts , Ares will experience 17% yearly earnings growth in 2023, which I think will be enough to justify another double-digit dividend increase. Additionally, the company had $678 million in spillover income at the end of 2022, more than 2.5 times the current quarterly dividend rate.
With a 13% weight in the portfolio, FS KKR Capital ( FSK ) is the second-largest stock holding in BIZD’s portfolio. The company recently increased its dividend for the first quarter, and more dividend increases are likely in 2023, as the company is expected to earn more than $3 per share in 2023, compared to $2.79 per share in 2022. Its aggressive share repurchase program would also increase the potential for dividend growth. As of the end of January 2023, the company had repurchased $87 million in shares as part of its $100 million repurchase program. The rest of BIZD's stock holdings, including Golub Capital BDC ( GBDC ), Main Street Capital ( MAIN ), Prospect Capital ( PSEC ), and Hercules Capital ( HTGC ) all received top-notch quantitative grades on dividend growth and yield from Seeking Alpha.
BIZD’s Total Returns and a Buying Opportunity
BIZD Total Returns Vs S&P 500 (Seeking Alpha)
Between 2020 and 2022, the BIZD share price outperformed the S&P 500 index, and when dividend returns are considered, the outperformance in comparison to the larger market index is even greater. Although the price of the ETF has lagged behind the broad market index so far in 2023, I expect this trend to reverse soon given that BDCs are currently trading at a significant discount with strong revenue and earnings growth potential. In terms of valuation, the majority of BIZD's top ten holdings received an A plus or an A grade from the Seeking Alpha quant system. For example, Ares Capital, FS KKR Capital, Hercules Capital, Sixth Street Specialty Lending ( TSLX ), Goldman Sachs BDC ( GSBD ), and Prospect Capital received an A plus on valuation, while Main Street and Golub Capital BDC received an A.
In Conclusion
As a median estimate for the S&P 500 to end 2023 around 4200 points appears bearish, adding a double-digit yielding ETF like BIZD to an investment portfolio could add stability to a dividend portfolio. BIZD increased its dividend by about 14% in 2022, and it seems that BDCs will be able to do the same in 2023 due to the strong demand for direct lending and floating investment portfolios. The strict underwriting policies of BDCs, combined with low default rates for middle-market firms, reduce the risk of credit losses that many traditional banks will face in 2023.
For further details see:
BIZD: BDCs Standing Tall Against Headwinds