BDC Weekly Review: The next recession will likely be very different

Darren415

This article was first published to Systematic Income subscribers and free trials on July 9th.

Welcome to another installment of our weekly BDC Market Review, where we discuss market activity in the Business Development Corporation (“BDC”) sector both from the bottom up – highlighting the people news and events – as well as top to bottom – providing an overview of the wider market.

We also try to add historical context as well as relevant themes that seem to be driving the market or that investors should be aware of. This update covers the period up to the first full week of July.

Be sure to check out our other weeklies – covering the CEF as well as the prime/baby bond markets for insights across the entire income space. Also see our introduction to the BDC industry, with a focus on how it compares to credit CEFs.

Market action

It was a good week for BDCs as credit assets continued to recover from their June slump. Only two BDCs are down so far in July: the underperforming FCRD as well as BXSL which fell on its last lockout expiry and which we discuss in more detail below.

Year-to-date, most of the sector remains in the red, however, the year-to-date total return has returned to single digits.

Return BDC YTD

Systematic income

The sector continues to steadily dig itself out of its hole, as seen below.

BDC Index

Systematic income

The valuation of the sector stands at 93%, which is well below its historical average, although it is skewed by the fact that Q2 NAVs are expected to fall, i.e. the valuation of Likely Q2 NAVs are a few percentage points above their current level.

Average BDC Rating

Systematic income

Market themes

A recession over the next year is becoming the baseline scenario for many analysts and investors. One of the ways we have assessed the allocation to BDCs in view of the recession is to see which have remained the most resilient to bouts of recession.

However, an obvious challenge with this approach is that not all recessions are created equal. Some recessions are less damaging to the corporate sector and others more so. And some companies can go through some types of recessions and fail in others. As they say on the box – “past performance does not guarantee future results”.

Let’s quickly review some of the recent recessions.

covid (2020) – this was by far the shortest recession in modern times, as a partial shutdown of the economy was offset by historic fiscal and monetary stimulus. The business sector managed with little overall disruption, although some sectors such as retail and hospitality were heavily affected.

energy shock (2015) – not technically a recession. About a quarter of the energy and natural resources sector went bankrupt due to falling oil prices, driven by the surge in US oil production. The damage was largely localized in the energy space with limited spillovers to other sectors.

GFC (2008) – the subprime crisis which spread to the financial sector and then to Main Street, during a relatively long period of 18 months.

Internet (2001) – was relatively brief and shallow due to the bursting of a speculative bubble in technology companies.

The next recession is unlikely to be caused by a single-sector blowout like the 2015 period. On the contrary, the energy sector could outperform if energy prices remain high. We are also unlikely to see the kind of chaos in financial markets that we saw at the GFC, as banks are in much better health. We are also less likely to see the kind of fiscal support we have seen during the COVID period and much less support from the Fed as it will be limited by inflation. Overall, it looks like the next recession could be relatively shallow, given the relative health of the household and corporate sectors, but it could be prolonged as the Fed won’t be able to cut rates as much. quickly than in the past.

So while BDCs shouldn’t necessarily be expected to repeat their performance over the next few months, we can have some confidence that the quality of underwriting and corporate support should always contribute to differentiated performance. This is why it is always advisable to take a look at how the different BDCs have performed in previous periods when allocating in the current environment.

BDC NAV

BDC Systematic Income Tool

Market Commentary

Saratoga Investment Corp. (SAR) posted a 2.5% realized/unrealized net change impact on net asset value for the quarter ending May. It is a good canary in the coal mine as it pays a month earlier than almost any other BDC.

The only thing to keep in mind is that in May, high yield credit spreads closed around 4.2% and ended June at 5.9%. Publicly traded bond valuations do not translate directly to private loan valuations, however, the ratios should be roughly comparable. It’s probably fair to list something like a 3-4% drop in the average decline in net asset value for the sector in the second quarter if we use the SAR as a benchmark.

Saratoga Investment NAV per share

SAR

Position and takeaways

This week, we saw a 9% drop from peak to trough in the Blackstone Secured Loan (BXSL) price as the final lock-up expired. The stock has since recovered about half of the decline. We took advantage of the fall to increase the stock in our income portfolios. As of this writing, BXSL is trading at an 88% valuation, which is 5% below the industry average. In our view, this is attractive in the context of the company’s track record and low fee structure, and the stock currently carries our “Buy” rating.