Dividend Cut Alert: Bad News For BDCs

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Dividend Cut Alert: Bad News For BDCs

seekingalpha09-05

BDCs have outperformed REITs since early 2022 due to rising short-term interest rates and a strong economy, but dynamics shifted in July.With long-term rates declining and recession fears rising, BDCs...

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TimAbramowitz Business development companies (BIZD) have been on a great run since early 2022 when the Federal Reserve began hiking interest rates. During that period, they have significantly outperformed other high-yield sectors, such as REITs (VNQ), by a wide margin. Data by YCharts This makes sense because the economy was on surprisingly strong footing and short-term interest rates were rising, both of which are strong tailwinds for BDCs. They tend to lend to riskier middle-market businesses with floating rate loans that are indexed to short-term interest rates. Meanwhile, REITs generally are more defensive in nature, as they rent out mission-critical assets to a wide variety of tenants, including many times investment-grade counterparties with long-term leases. Additionally, REITs’ cash flows generally are viewed as bond-like substitutes, which means that when interest rates rise, the net present value of those cash flows is reduced. However, since early July, the dynamics have changed. Over that period of time, REITs have meaningfully outperformed BDCs. Data by YCharts This is because long-term interest rates have been coming down, and expectations are growing for Federal Reserve rate cuts starting this month and continuing in the months and quarters to follow. Additionally, fears of a recession have increased due to some negative economic data points being released, which threatens BDCs more than REITs. Combined with the fact that BDC dividends tend to be thinly covered due to the requirement that they pay out 90% of their taxable income as dividends, a double whammy of an economic downturn leading to a spike in non-accruals and defaults, alongside declining net investment income due to Federal Reserve rate cuts, could very well lead to numerous dividend cuts in the sector. In this article, we will discuss one BDC that has already slashed its dividend and four others that are at risk of potentially cutting their dividends, as well as several that we think are fairly well-positioned to weather modest headwinds from interest rate cuts and an economic slowdown. BDCs At Risk One BDC that recently slashed its dividend by a whopping 25% is TriplePoint Venture Growth (TPVG), leading to a steep decline in its stock price: Data by YCharts Net investment income declined by a significant 33% year-over-year in its most recent quarter. TPVG continues to be at risk for further dividend cuts due to about 30% of its net investment income coming from payment-in-kind interest on its loans (i.e., they are not paying cash to TPVG). Moreover, a large portion of its portfolio is at risk, including about 25% of the portfolio based purely on management’s own internal ratings. As a result, TPVG may not be done cutting its dividend. Other BDCs whose dividends are potentially at risk include CION Investment Corporation (CION) and Prospect Capital Corporation (PSEC), both of which generate a lot of their interest income from payment-in-kind loans. While both of these appear to have dividends that are fully covered for now, any material decline in the credit quality of their portfolios—which is very possible in the event of an economic slowdown and/or meaningful headwinds from Federal Reserve rate cuts—could push them over the edge into cutting their dividends. Meanwhile, SLR Investment Corp. (SLRC) only has about a 9% coverage ratio of its dividend, so a combination of rate cuts as well as economic weakness could push it to a dividend cut. Last but not least, Oaktree Specialty Lending (OCSL) has a 1.0x dividend coverage ratio as per its last quarter. This is despite the company executing a one-time management fee waiver to ensure it fully covered the dividend. While Oaktree is a reputable manager with one of the more defensively positioned portfolios in the space, and its loan book and balance sheet are less exposed to income headwinds from declining short-term interest rates than many of its peers, it has seen a spike in non-accruals recently. Even though management has reduced base management fees substantially which will be taking effect this quarter to offset the impact of the one-time waiver rolling off from the previous quarter, the combination of meaningful impending rate cuts and a potential economic downturn could push OCSL into cutting its dividend. While we do think the dividend is somewhat at risk with OCSL, the discount to net asset value, combined with its low management fee, stronger balance sheet, defensively positioned portfolio, and reputable management, still make it an attractive risk-reward for long-term investors willing to deal with potential volatility from a dividend cut in the short term. It is also important to note that OCSL hiked its dividend more aggressively than many of its peers in recent years, which puts it at greater risk of a dividend cut. Data by YCharts However, we are happy to see OCSL prioritize returning capital to shareholders, even if it means they have to trim the dividend some during the upcoming cycle. Still, investors should not be blind to the fact that a dividend cut is a very real possibility for OCSL, which could lead to short-term stock price volatility. BDCs That Are More Conservatively Positioned For investors concerned about having a lower risk of a dividend cut, higher-quality BDCs like Main Street Capital (MAIN), Ares Capital Corp. (ARCC), Golub Capital BDC (GBDC), Blackstone Secured Lending (BXSL), Morgan Stanley Direct Lending (MSDL), and Blue Owl Capital Corporation (OBDC)(OBDE) all have dividend coverage ratios that are meaningfully higher than these aforementioned investments relative to their base dividends and are not as exposed to PIK loans. Moreover, they all have investment-grade balance sheets and either proven track records of underwriting excellence or significant exposure to senior secured first-lien loans in their investment portfolios (and in some cases both), which should enable them to hold up better in the event of an economic downturn. Investor Takeaway  Although no BDC dividend is perfectly safe, especially in the face of a double headwind from declining short-term interest rates and a potential economic slowdown, investors in the BDC space can greatly reduce their risk by insisting on quality dividend coverage. This double headwind is the main reason why I am keeping my exposure to the sector underweight in the current environment.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"hasMoreComments":false,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false}}