4-Mar-2022
One of the key themes of the recent earnings period was a significant number of dividend hikes. About half of the BDCs that have reported have also hiked dividends. These include the Capital Southwest (CSWC), Ares Capital (ARCC), Hercules Capital (HTGC), Fidus Investment (FDUS), Barings BDC (BBDC), TCG BDC (CGBD) and the PennantPark Investment (PNNT).
These dividend hikes are reflecting five different dynamics. First, non-accruals have generally trended lower since the start of the post-COVID recovery period. The chart from ARCC is shown below. BDCs have different ways of dealing with non-accruals – the positions can be sold to other investors, they can be cured “organically”, they can be restructured into equity, or they can be written down. Not all of these scenarios will result in additional income generation but a number of them will.
Second, the strong performance of equity markets into Q4 has allowed BDCs to rebalance from their equity holdings into income-generating securities, just as a 60/40 investor would normally reallocate from her equity holding into bonds when stocks outperform bonds, generating more income in the portfolio. PNNT is one BDC which is explicitly following this strategy. Despite a NAV NII yield that is more than 2% below the sector average (even with the recent hike), the company has outperformed the sector in total NAV terms which has helped it rotate into first-lien loans, boosting its income levels and allowing it to make its large hike recently.
Third, the BDC sector has enjoyed a downtrend in debt costs over the previous nearly 2-year period – see red bars in the FDUS chart below. This has been a function of both a sharply lower Libor – the base rate for credit facilities as well as a drop (until recently) of longer-term corporate debt yields, allowing BDCs to refinance their unsecured debt at lower rates.
Fourth, prepayment activity has been very strong. Part of this is the seasonal impact of the last quarter of the calendar year which tends to see more repayment events such as M&A and IPOs. This was particularly the case in 2021 as the year finished very strong in terms of investor risk appetite as well. The chart below shows what an outlier Q4 fee level was for CSWC – Q4 2020 was an outlier as well though not to the same extent.
Fifth, the number of rate hike expectations has increased very quickly over the past few weeks – from 3-4 at the end of 2021 to 7 now being close to the consensus. Based on current market expectations gleaned from the Fed Funds futures market, BDCs should get a 6% NII uplift in aggregate by the end of this year. 3-Month Libor has already moved to 0.50% from a low of 0.11% last year – a start of the process which will allow managers to continue to increase dividends.
Overall, it has been a terrific environment for BDCs particularly as the overall default rate has stayed very low. Supply chain issues have driven up production costs for some portfolio companies and/or limited their unit sales, however, many have been able to make up for this by passing on price rises to consumers. A relatively competitive environment has also pushed new investment yields lower, however, many BDCs have been able to offset that with a modest rise in leverage.
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