Barings BDC: Solid BDC But Lack Of NAV Growth Reduces Appeal

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Barings BDC operates as a business development company that generates its earnings through a portfolio of debt investments.BBDC's portfolio is highly diversified, with 66% in first lien senior secured...

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Since I last covered Barings BDC (NYSE:BBDC) back in May, it has provided a total return of 8.7% which has outpaced that of the S&P 500. At the time, BBDC was trading at an attractive valuation and showed portfolio strength to navigate the higher rate environment. I wanted to revisit BBDC now that the current outlook around interest rates are anticipated to change and become less favorable for business development companies. Barings BDC operates as a business development company that generates its earnings through various forms of debt investments to middle market companies. However, a big driver of my caution here is that BBDC has not been able to grow NAV at a meaningful rate, despite conditions being the most ideal for their portfolio of floating rate investments. Just to be very clear, the NAV has remained in the same range, but I just had higher expectations for BBDC. While the lack of growth doesn't come close to warranting a sell for existing shareholders, it simply limits the appeal for initiating a confident position in their future growth. Just as a point of reference, we can see that BBDC has outperformed VanEck's BDC Income ETF (BIZD) in total return on a year to date basis. I wanted to provide some update thoughts on why this outperformance may continue and why BBDC is a strong candidate to maintain BDC exposure through future interest rate cuts. One of the main appeals of BBDC is the large dividend yield of 10.6%, which has the ability to rapidly compound your dividend income when held over a long period of time. Data by YCharts Portfolio Strategy Part of BBDC's strength is that their portfolio aims to maintain a high level of diversity across industries so that the level of concentration risk can be limited. BBDC contains a majority of exposure to finance and insurance companies, accounting for 17% of their portfolio. This is followed by investments in service-based businesses and high-tech industries, accounting for 15% and 11% respectively. BBDC maintains a portfolio size of about $2.4B, which is spread across 329 individual issuers. As of the latest update, the top issuer only accounts for 6.3% of their total exposure, while the top ten issuers make up 24% of their portfolio. BBDC Q2 Presentation I tend to favor BDCs that have the majority of their investments structured on a senior secured basis. Approximately 66% of their debt investments are on a first lien senior secured basis, while an additional 6% is on a second lien senior secured basis. This focus on senior secured debt is a risk measure that ensures BBDC's debt sits at the top of the corporate capital structure for borrowers. Being at the top of the capital structure ensures that BBDC's debt has the highest priority for repayment, which can help is cases where a portfolio company is going through a bankruptcy and liquidating assets. It helps decrease the probability that all invested capital is lost in a bad investment. Additionally, BBDC has been a great place to park cash to counter these high interest rates because their portfolio is comprised of 87% floating rate investments. A floating rate structure has helped BBDC generate higher earnings because higher rates directly translate to higher interest income that BBDC can collect from borrowers. While higher rates can be beneficial from an earnings standpoint, it can also be a source of stress for borrowers that are underperforming and have thinner margins. However, the underwriting here by management has been excellent, as the portfolio contains a weighted average interest coverage ratio of 2.1x. Financials During the first week of August, BBDC reported their Q2 earnings and the result were Solid. Most notably, net investment income landed at $0.40 per share, beating estimates by $0.10. However, total investment income for the quarter amounted to $74.9M, which beat estimates but was also a 0.5% year-over-year decrease. Taking a look at some metrics on the balance sheet, I am losing a bit of confidence in the growth potential of BBDC. Their investment portfolio at fair value has slightly decreased, while their total net assets have also not shown any growth over the last year. BBDC Q2 Earnings During Q2 of 2023, NAV per share sat at $11.34. Despite being in the most favorable conditions for earnings over the last decade, BBDC's current NAV sits at $11.36 per share, representing a tiny growth of $0.02 over the last twelve months. Management has continued to make new investments throughout the quarter, with $38.5M being allocated towards nine new investments in the most recent Q2. Similarly, BBDC committed another $40M towards existing portfolio companies. However, it seems like the repayments are coming in faster than management can reinvest the capital in new opportunities that can generate higher earnings. There were 15 loans repaid during the quarter, totaling $116.2M. However, I will give credit where its due as BBDC's liquidity profile has greatly improved over the last quarter. Cash and foreign currencies total $84.3M, showing an increase over the prior quarter's amount of $64.1M. While the cash positions grow, BBDC simultaneously reduced their borrowings under credit facility be decreasing it down to $350.8M. This is an improvement from the prior year's amount of $772M, as well as last quarter's total of $440.3M. Valuation & Outlook Since BBDC operates as a business development company, the price can vary from the actual value of the underlying net assets. When I last covered BBDC, the price traded at a large discount to NAV of 14.6%. The price currently trades at a similar discount to NAV of 13.8%, which I still believe to be an attractive entry point for investors that may have higher confidence levels than I have. For reference, the price has traded at a three-year average discount to NAV of 17.26%. CEF Data Since BBDC has failed to capture any meaningful growth during a period of higher rates, I believe that it this discount may get larger as the price comes down as a result of interest rate cuts. The Fed's latest statements around interest rates have the markets anticipating cuts this September. After all, unemployment has consistently trended upward over the last twelve months and now sits at 4.3%. As the number of households out of work grows, this will cause a shift in consumer spending as people start to reduce their spending levels. This may incentivize the Fed to start reducing rates as a way to help stimulate the economy and offset the rising unemployment level. We can see how the BBDC and the federal funds rate have shared an inverse relationship. When rates were cut to near zero levels, the price of BBDC increased. Conversely, when rates were hiked to a decade high, BBDC's price retracted. Lower rates created an environment that favored borrowers, as they were able to access debt at more affordable rates. However, higher rates make it less appealing to hold debt on the balance sheet and ultimately limits the volume of borrowers there are in the market. Data by YCharts However, a byproduct of lower rates would be that BBDC's net investment income is negatively impacted as they are no longer able to pull in higher interest income from borrowers. We can see this story play out if we look back on the earnings history for BBDC. When rates were still at near zero levels in Q1 of 2022, BBDC only generated net investment income of $0.23 per share. As rates started to get hiked, BBDC's earnings increased alongside. Therefore, when rates come down, there's a good chance that net investment income will reduce one again. Seeking Alpha It ultimately comes down to how efficient management can capitalize on the changing environment. There's also the possibility that lower rates cause an influx of borrowers for BBDC to utilize as a source of portfolio growth. This would allow management to put that cash to use and effectively offset any negative impacts in earnings with new portfolio companies. Wall St. seems to have confidence in BBDC based on their average price target of $10.29 per share. This represents a modest upside potential of 4.5% from the current price level. Dividend As of the most recently declared quarterly dividend of $0.26 per share, the current dividend yield sits at 10.6%. One thing that I am very confident in is management's ability to continue supporting this dividend into the future. As previously mentioned, net investment income for the quarter landed at $0.40 per share. This translates to earnings to distribution coverage rate of 153.8%, meaning there is plenty of cushion here in case earnings are negatively impacted from future interest rate cuts. Therefore, current income oriented investors can sleep well at night knowing that BBDC's distribution is well-supported by earnings and there is very little chance of a reduction. Seeking Alpha Since the distribution is so well-supported, I anticipate plenty of distribution raises into the future. We've already seen how strong the dividend growth can be throughout recent years. For instance, the dividend has increased at a CAGR (compound annual growth rate) of 16.24% over the last five-year period. It seems like management values the distribution growth over time, even if it chews into the portfolio, retaining more earnings that can contribute to NAV growth. This has enabled shareholders to compound their distribution income throughout the holding period. In order to demonstrate this growth, I ran a back test of an original $10,000 investment at the start of 2019. The blue bars below represent the annual income amount for each respective year. This graph assumes that all dividends were reinvested back into BBDC to accumulate more shares. In addition, it is also assumed that a fixed monthly contribution of $500 was added throughout the entire holding period. Portfolio Visualizer In year 1 of your investment, the annual dividend income received would have amounted to $802. Fast-forward to the full year of 2023 and your income would have grown to $5,557. This represents a sizeable income growth of 6.9x over a five-year period. However, it should be noted that the distributions received from BBDC are classified as ordinary dividends. Ordinary dividends have less favorable tax consequences than qualified dividends you'd received from traditional dividend growth stocks. Therefore, a position in BBDC may be best utilized in a tax advantaged account. Risk Profile When it comes to measuring the risk profile of a business development company, I like to reference the non-accrual rate of their investment portfolio. These non-accruals represent the rate of portfolio companies that are significantly underperforming and can no longer keep up with the required debt obligations on their loans. When I previously covered BBDC, non-accruals sat at a very impressive 0.3% of fair portfolio value. This is extremely low in comparison to some of the other popular BDC out there.  CION Investment Corporation (CION): non-accrual rate of 1.36% of fair value. Ares Capital (ARCC): non-accrual rate of 0.7% of fair value. Main Street Capital (MAIN): non-accrual rate of 1.2% of fair value. WhiteHorse Finance (WHF): non-accrual rate of 5.7% of fair value.  With these peers in mind, I am very happy to see that BBDC's non-accrual rate remains at the same level of 0.3% of fair value and 1.5% of the portfolio on a cost basis. This is a testament to the management's strong underwriting ability to careful select investments that are able to continue navigating this higher interest rate environment and continue paying their required debt maintenance. Interest rates sat at their decade high for about a year straight now and if BBDC's portfolio companies were able to remain healthy in this environment, there's a good chance that conditions will continue to improve as interest rates get cut. Takeaway  In conclusion, I maintain my buy rating on BBDC because of the strong dividend coverage, diverse portfolio offerings, and strong underwriting that has resulted in low non-accruals. However, I do remain a bit cautious about the BDC's ability to capture and retain the underlying growth of NAV. Despite operating in a higher interest rate environment, the NAV growth over the last year has been lackluster. However, the price still trades at an attractive discount to NAV valuation and if you have confidence in management's ability to continue growing their portfolio making smart investments, this may be an attractive opportunity to accumulate shares. 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