February 22, 2021 BARRON’S 37
INCOME INVESTING
As of 3Q 2020,about 4.5% of the loans in BDC
portfolioswere overdue by 90 days or more,
the highest in four years, Truist analysts said.
How to Pick the BDCs
With the Safest Yields
And Best Loan Books
I
ncome investors may want to
pay attention to business devel-
opment companies’ earnings
this month: Those that report
stable loan portfolios could
deliver some healthy yields.
The vehicles, known as
BDCs, are among the only ways that
individual investors can lend to midsize
companies that are too small for tradi-
tional bond offerings. BDCs generally
raise money in both equity and bond
markets and lend to those companies
directly, or buy their loans.
The draw for investors is that these
midsize companies pay higher yields
to borrow than bond-market giants like
Apple(ticker: AAPL) orMicrosoft
(MSFT). And BDCs have similar divi-
dend rules as real estate investment
trusts: They must pay out 90% of their
net income as dividends to get prefer-
ential tax treatment. The Cliffwater
BDC Index yielded 9.1% as of Feb. 17.
By contrast, long-term Treasuries
yield around 2.1%, even after a steady
drive higher over the past four
months. The investment-grade corpo-
rate bond market yields less than 2%,
and junk bonds yield less than 4%.
In all three of those markets, interest
rates are fixed, so rising yields and
interest rates can dent returns.
BDCs, however, often lend at float-
ing rates. That means that if short-
term U.S. interest rates eventually
rise, those loans’ interest rates will
rise, as well. That might be years
away, but it does help investors dodge
risk of paper losses that hit fixed-rate
bonds when yields rise.
The downside is that midsize compa-
nies pay higher rates for a reason. They
are smaller and tend to be less insulated
against business disruptions of the type
that happened during the pandemic. As
of the third quarter of 2020, about 4.5%
of the loans in BDC portfolios tracked
by analysts at Truist were overdue by
90 days or more, the highest in four
years, according to a recent note. That
compares with about 1.6% before the
pandemic, the analysts wrote.
That makes it important for inves-
tors to be careful in choosing manag-
ers, says Andrew Kerai, portfolio
manager and senior credit strategist
at RiverNorth. Until the middle of last
year, Kerai, who helps manage the
RiverNorth Specialty Financefund
(RSF), was interested primarily in
BDCs’ unsecured bonds, in part be-
cause the sector has leverage limits
imposed by regulators.
But when the sector’s equity started
to sell off, the fund started to buy
more shares, as more BDCs traded
at a discount—and with hefty yields.
“On the equity side, I think our
strike zone is a lot narrower than
some people’s,” he said. “It’s got to be
a top-tier manager, a [loan] book that’s
good quality, with good liquidity and
trading at a reasonable discount. Com-
ing into Covid-19, all those things were
all hard to find.”
As of Sept. 30, 2020, the fund
owned shares of seven BDCs, including
Oaktree Specialty Lending(OCSL);
MVC Capital, which has since merged
withBarings BDC(BBDC);Bain
Capital Specialty Finance(BCSF);
andAres Capital(ARCC), according
to Securities and Exchange Commis-
sion filings. About 14% of its fund was
invested in BDC shares, compared with
40% in bonds issued by BDCs. But
those bonds generally offer lower
yields than the shares; most yield less
than 5%, and many yield less than 3%.
Investors may have missed out on
the steepest discounts on the equity
side. BDCs’ valuations are no longer
weighed down by a wide investor
panic the way they were during the
height of the Covid-19 scare last
March. The Cliffwater BDC Index was
recently trading at a discount of 0.6%
on Feb. 17, compared with discounts of
nearly 50% last April.
There are still a few factors that
could work in BDCs’ favor from here,
however. Perhaps the biggest is a rally
in risky debt that has pushed yields
on low-rated bonds lower. Bonds rated
CCC+ or below—the lowest-rated
bonds not in default—have rallied 2.4%
for the year through Wednesday, ac-
cording to ICE Indices. That outperfor-
mance may bode well for BDCs, seen
as one step down in credit quality and
size, according to strategists at credit-
research firm CreditSights.
And credit quality might be starting
to look brighter in private markets,
where lenders are seen as being more
willing to negotiate with borrowers to
amend loan terms and avoid messy
defaults. According to law firm
Proskauer Rose, the default rate for the
fourth quarter of 2020 was 3.6%, down
from 4.2% the prior quarter and 8.2%
in the second quarter of last year.
In fact, analysts have been pointing
to a very different type of risk for BDCs
and private lenders more recently: the
risk that borrowers will start paying
back loans early, removing sources of
yield sooner than expected. Those risks
are offset with fees, particularly for
younger loans.
“While we expect repayment activ-
ity to increase going forward for all
BDCs, the younger the portfolio, the
greater the probability that a repay-
ment will generate more material yield
enhancement income (prepayment
fees, accelerated amortization) that
flows to earnings,” wrote Robert
Dodd, analyst at Raymond James,
in a December note on the sector.
As of that note, the two BDCs with the
“youngest” portfolios were Barings
BDC andOwl Rock Capital(ORCC).
BDCs might also find more oppor-
tunities to make new loans at rates
that are attractive to investors, says
Truist. In a Feb. 4 note, the bank’s
analysts said they favor Ares Capital,
FS KKR Capital Corp. II(FSKR),
Owl Rock Capital, andSixth Street
Specialty Lending(TSLX), the last
of which pays a variable dividend.
More recently, earnings have been
in focus, and the news seems to be
good there, as well. Of the roughly
dozen BDCs that had reported earn-
ings through Feb. 11, according to
Dodd, the share of portfolio loans
with late payments has declined to
close to 3%, down from levels above
4% the prior quarter.
“Credit quality looks to have
broadly improved and is quickly
coming back to pre-Covid levels, if
not even better,” wrote Dodd.
Even so, there are plenty of reports
yet to come, with 38 BDCs in Cliff-
water’s index. And the performance
of different managers’ portfolios can
vary a lot. So, investors should stick
with BDCs with proven track records
and strong management teams, and
not be lured into higher-yielding
names trading at steep discounts.
“Only pick the top-tier names,”
Kerai said. “Don’t ever stretch for
lower-tier names, and don’t ever
stretch for yield.”B
By Alexandra
Scaggs
BDCs Bounce Back
Publicly traded lenders have mostly recovered from the
pandemic panic.
Sources: Cliffwater, BloombergCliffwater BDC Total Return Index
350030002500200015001000Feb. 2019 2020 2021