This article offers three explanations for the recent strong performance from high-yield BDCs, three reasons why they’ll likely underperform going forward, we consider three counterpoints to our thesis, and we highlight three specific BDCs (Prospect, Main Street and Fidus) that seem particularly overvalued right now. Finally, we offer 7 specific high-yield REIT ideas (ranked from best to worst) that offer an attractive alternative for income-focused investors.
The market can remain irrational longer than you can remain solvent. –John Maynard Keynes.
We believe the market is extrapolating recent strong performance for Business Development Companies (“BDCs”) too far into the future. We have no interest in shorting BDCs, however we did reduce our exposure earlier this year because we believe many of them will underperform and there are better opportunities elsewhere…
Three reasons why BDCs have been such great performers
Business Development Companies, as measured by the BDC ETN (BDCS), were are up 25.1% over the last year (total return) versus the S&P 500 (SPY) gain of only 16.6%. For more perspective, the following chart shows the one-year total returns for the largest BDCs versus the S&P500 (SPY). They’ve all outperformed significantly (except for FSIC, which missed earnings expectations last quarter).
And of the largest BDCs that have been around since the depths of the financial crisis (i.e. over the last eight years), they’ve all significantly outperformed the S&P 500, as shown in the following chart (except for Prospect Capital, which did still deliver healthy returns).
There are several reasons why BDCs have performed so well in recent years, including low interest rates, a favorable regulatory environment, and the existence of many lucrative distressed opportunities.
1. Low Interest Rate Environment
For starters, the prolonged artificially low interest rate environment since the financial crisis has pressured many income-hungry investors to buy high-yield BDCs. The US Fed was trying to stimulate the economy with low interest rates that would force investors off the sidelines (e.g. out of savings accounts, treasuries, and low-risk corporate bonds) and into aggressive growth investments that would spur economic growth (e.g. BDC’s exist to help grow small and mid-sized businesses).
2. Favorable Regulatory Environment
The regulatory environment has been favorable for BDCs. Specifically, BDCs have had little competition from the banking industry since the financial crisis because regulations were forcing big banks to de-risk. And as banks moved away from the distress opportunities, BDC benefitted. In fact, a big part of the reason BDCs have been able to put up such great total returns in recent years is because the market was filled with lucrative, high-yield, high-ROE distressed opportunities, and there was essentially no competition from the banks. For many small businesses that needed access to capital, BDCs were the only option. And because BDCs took advantage of these opportunities, they have been able to deliver big attractive returns for investors.
3. High yield market distress
High yield market distress in early 2016 is the main reason BDCs have delivered such strong returns over the last year. In particular, low energy prices caused heightened default-risk in the high-yield energy debt markets, and BDCs sold off right along with energy debt. Essentially, the strong one-year returns for BDCs is because the prices were much lower one-year ago. In fact, they should not have been as low (in our view) because the selloff was inappropriately tied to the distress in high-yield markets caused by energy companies (this distress impacts BDC differently based on their book of business, but the market indiscriminately sold off).
For more perspective, this next chart shows high-yield spreads, which are basically the difference in yield between riskier high-yield bonds and safe US treasuries. Remember, BDC portfolios essentially consistent of higher risk loans and financing arrangements (similar to high yield bonds).
And as the chart shows, the spread was significantly higher in early 2016, which is not-coincidentally the time when BDCs were trading at much lower prices. Also important, the spread was extremely high in 2008-2009 (i.e. the financial crisis), and this has benefitted BDCs significantly as they were able to make loans in the years after the crisis that appeared very risky at the time (thereby providing high yields), but proved quite lucrative as the markets have since recovered thereby providing outstanding returns for BDCs.
Three reasons Why BDCs will be challenged going forward
BDCs have been great performers recently, but we believe they will be challenged to deliver similar strong returns going forward because competition will be stronger, distress opportunities are not as pervasive, and valuations are already high.
1. Increased competition
BDCs will face increased competition on multiple fronts. First, with almost all banks now passing regulatory stress tests, they have more freedom to choose opportunities that will be more lucrative to them (for example, providing capital to middle market companies thereby providing some increased competition for BDCs). Also, the new Trump administration seems focused on rolling back regulatory “burdens” in general, which could mean more competition for BDCs from banks. Also, with the “zero interest rate environment” now in the rear view mirror, and interest rate expectations continuing to rise, investors may be more comfortable with the improved yields offered by corporate bonds (and other income-paying securities) in the coming years thereby putting selling pressure on BDCs which were formerly one of the few higher yield opportunities available.
2. Special dividends may be reduced
Special dividends may be reduced or eliminated by many BDCs going forward because the high return-on-equity distressed investment opportunities (i.e. buying distressed assets for cents on the dollar) may be largely gone for now (until the next market crisis anyway). Many BDCs have achieved very high ROE in recent years (in addition to net investment income) because the market distress allowed them to make some very lucrative deals. It seems far fewer of those types of lucrative distressed opportunities are available now, and so too will special dividends be less common, in our view.
3. Valuations are high
As the following chart shows, BDCs are now trading closer to the higher-end of their historical price-to-book values, an indication that they may have less price appreciation potential via multiple expansion as they have experienced in recent years.
Plus, with less opportunities (less distress) and more competition (less regulations and growing higher-yield alternatives), BDC’s will be very challenged to deliver the type of returns they’ve delivered in recent years, and many investors may end up being disappointed.
Three counterpoints to consider (playing “devil’s advocate”)
1. Increasing Interest Rates
To briefly play “devil’s advocate,” we could argue that BDCs will continue to perform well going forward because increasing interest rates will benefit BDCs in much the same way they benefit banks (i.e. widening net interest margins will improve bottom-line profitability). After all, many BDCs have a favorable amount of floating rate interest payments coming in but their own debt payment are fixed. However, let’s not forget that the strong recent historical gains for BDCs have been driven not just by interest income, but also by strong asset appreciation (for example, realized gains on investment exits). And the strong gains have been fueled by markets rebounding