25-Feb-2022
With the next Fed meeting now less than a month away this week, we take a look the impact of the expected Fed rate hiking trajectory on BDC sector aggregate income levels.
It’s worth highlighting that Libor has already begun to rise in response to more persistent inflation and a more hawkish Fed rate path profile. 3-Month Libor is trading around 0.4% as of this writing – having doubled from a level of around 0.20% about a year ago and 0.25% just a month ago. Going forward, we would expect Libor to roughly move in line with the Fed policy rate – perhaps leading it somewhat as it is a 3-month rate and is based off expectations of short-term rates over the coming three months rather than where they are now.
This is how the market expects the Fed Funds rate to evolve over the coming 15 months.
Let’s translate that into BDC income levels based on company disclosures in our coverage universe. The chart below shows the median net investment income or NII trajectory. For the first three hikes or so, we expect a drop in NII of about 1.4% – what we call the NII Valley – and a subsequent rise.
What is interesting is how quickly we are expected to move through the NII Valley. By the July meeting, NII is expected to be above its starting point as of today, all else equal.
It’s obvious from the chart that the key risk to BDC investors is that something happens that allows the Fed to pause after only 2-3 hikes which would keep the BDC sector in the lower part of the NII path. This could be something like a significant drop in inflation, a sharp deterioration in the labor market or a market crash.
Something else to highlight is the significant dispersion around these numbers – as the following chart shows using information from our service BDC Tool. This dispersion is primarily due to the composition of individual BDC liabilities – BDCs with a larger percentage of fixed-rate liabilities (i.e., bonds rather than credit facilities) will see a quicker and stronger uplift in NII than those financed primarily with floating-rate liabilities or those that hedge their fixed-rate liabilities.
An expected increase in BDC income and, hence dividends, is certainly welcome. However, it does also pose a question of whether investors should expect an uplift in prices as a response to this positive income trajectory.
In our view, a big chunk of this expected performance uplift has already happened even though it may not seem like it. BDCs have registered modestly positive returns since the start of the year, however, those modest returns have outperformed the rest of the income space, except for MLPs.
BDCs tend to follow broader risk sentiment, however, they have recently decoupled from stocks as the chart below shows.
These two developments signal to us that the BDC market has already begun to price in expected NII increases.
BDC sector trailing-twelve month yield is on the lower side of its historic range which suggests that dividends could rise without triggering a large price rally as well. This would allow BDC yields to move back closer to their historic levels from currently depressed levels.
We get a roughly similar picture, particularly over the last 5 years if we look at BDC yields relative to high-yield corporate bonds or 10Y Treasuries.
That said, we do think BDCs should see modest price rises as dividend raises begin to filter through. In our view, it makes sense to tilt to certain BDCs that are trading at modest valuations and that are expected to see outsized growth in NII. One such BDC that is the TCP Capital Corp (TCPC) that should see one of the largest NII uplifts and remains attractively valued at a 97% price/Q3 NAV ratio.
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