Better Late Than Never
Due to the press of other business, we're a little delayed in writing our weekly market snapshot. Still, we believe there's a value in keeping track on a regular basis of how the market is shifting and what is happening to the Expected Returns over time. (In that regard, don't forget to glance down the Expected Return Table to see how key metrics we follow have changed from week to week since the beginning of 2023).
This last week, we made changes to our projections for Gladstone Capital (GLAD) and Gladstone Investment (GAIN) not so long after our last updates. Both BDCs are very hard to project out given the type of assets they're invested in (GAIN) and their changing dividend policies, which are at variance with what we have become accustomed to (GAIN/GLAD). We've increased our dividend expectations for both BDCs (a lot for GLAD, barely anything for GAIN) and written Updates for both BDCs to explain ourselves to anyone interested in the logic behind the numbers.
A second factor that affected prospective returns this week - and every week - was BDC stock price changes in the market. Most BDCs - and the sector - rose in price, slightly reducing the average Total Return to 124.2% over 5 years, from 127.5% last week and 129.2% at the 2023 peak. The average yield - based on our 2023 dividend projections and the stock price at the April 16 close - is 13.5%, down from 13.7%.
Sitting On Their Hands
Nonetheless, there are still 32 BDCs which - if you "buy into" our projections - are slated to return over 100% over 5 years. That's roughly three-quarters of the BDC universe and demonstrates - for yet another week - how reserved investors remain. The S&P BDC Index on a price return basis is down (18.4%) from its height about this time last year and (19.0%) from just before the pandemic. These may not be the worst times for BDC investors with the S&P index nearly 12% off its bottom set in September 2022 and 4.4% above the 2023 YTD nadir, but the several weeks of good feelings that were cut short by the Silicon Valley Bank disaster have not returned.
We don't know where prices will go in the short run much as we'd love to. Earnings season is coming up and we're optimistic that BDC earnings will continue to shine and distributions - like those of GLAD most recently - will continue to climb. We're also surprisingly sanguine that BDC net asset values will hold up pretty well, despite a pick-up in unrealized and realized credit losses brought on - very deliberately - by the Fed's higher rates.
Last year in the first quarter, the BDC sector in aggregate recorded net realized gains of $204mn, with 25 of 42 BDCs in the black by this metric. This year in the first quarter we expect to see much more red ink, both realized and unrealized. Nonetheless, we're expecting net book values to hold up pretty well. Whatever material damage is coming to BDC balance sheets - if any - is still down the road.
Like us, the market seems to presume that real losses in BDC capital from credit losses are yet to come. Where we differ - if we do - is that we're not budgeting in almost every case for anything the BDCs cannot manage. Moreover, with interest rates still headed higher and most BDCs fully invested, any loss of income to bad debts will be more than offset by greater investment income from all the performing borrowers. The analysts are projecting a 12.2% increase in EPS for the sector in 2023 over 2022 and we're budgeting for an 11.2% jump in total payouts - in both cases spread over a plurality of the players. Our numbers - and we expect the same can be the same for the analysts - including provision for those higher credit losses.
Will the BDC sector hold its own and muddle through as we expect, or is a big drop in asset values, net book value, earnings, and distributions in the cards? This is the key issue on which the next year or so hinges. Given the modest level of BDC valuations, things are going to have to get pretty nasty before investors are at risk of incurring any red ink over the long term. Even a 20% reduction in BDC dividends from the projected 2023 levels would still allow investors to receive a double-digit yield. That's still materially better than the 4.50% you'd get investing in a 5-year CD at - say - BMO Harris and far more liquid. in the best case, the yield is 3x more than the relatively riskless CD.
Our impression is that many BDC investors sitting on the sideline are not true believers in these worst-case scenarios of mountainous credit losses and permanently lower distribution-paying power but are hoping the next guy is. A panic would offer an even more attractive entry point and there is a long history of investor panics to point to. Maybe when all the predictions of dark times ahead for the credit markets recede we'll see BDC investors wade back into the market en masse. That might coincide with rates slipping somewhat, making those high BDC yields all the more attractive.
In the interim, we're gearing up for BDC earnings season, just two weeks away. We're very curious to see if our relatively optimistic take on BDC fundamentals holds up in reality. If we're right that won't be any guarantee that matters could get much worse sometime later but will still be a sign that we're on the right path. If we're wrong, we'll reassess.