Potential BDC Rally In 2018

There are many reason for a potential BDC rally in the coming weeks including:

  • Many BDCs are currently trading within 5% of 52-week lows including (MCC, TCPC, ARCC, TCRD, NMFC, FSIC, KCAP, FDUS, AINV, GBDC, MRCC, and GSBD).
  • Investors seeking yield especially given 10-year treasury rates still below 2.4%.
  • Positive impacts from tax-reform including increased dividend income and equity valuation upside (higher NII and NAV per share).
  • Higher portfolio yields due to recent rise in LIBOR
  • Lower predictive BDC default rates.

Main Street Capital (MAIN) recently discussed the possibility of additional equity valuation upside if corporate taxes are reduced in the coming quarters.

“I would say modestly positive impact on our NAV because the way we value our lower middle market equity investments we have, we do a market approach and a DC up approach and with respect to the DC up approach you assume a C Corp buyer, buys the company and then in determining what they would pay, we have been assuming a 35% tax rate, maybe plus I don’t remember. While you drop that to 20% that drives up the DCF component of your valuation because your companies are worth more to a C Corp buyer.”

Equity participation is partially responsible for growing MAIN’s NAV per share as well as ‘recurring non-recurring’ dividend income, which contributes to the growing amount of undistributed spillover income used to support continued semi-annual special dividends.  

“We continue to seek and receive significant equity participation in our lower middle market investments, and as of quarter end, we owned on an average a 38% fully diluted equity ownership position in the 99% of these investments in which we currently have equity exposure.”

“When we evaluate new lower middle active investments, we focus on having the combined first lien debt in equity investments target a blended internal rate of return in the high teens low 20% range and a minimum current investment income contribution which allows us to first maintain and then subsequently grow our monthly dividend to our shareholders. From an underlying standpoint we achieve these targets by maintaining a discipline mix of debt and equity investments. With the typical initial investment comprised of approximately 75% to 80% debt and 20% to 25% equity and with very modest growth assumptions for this equity investments.”

Moody’s predicted a fall in the global junk bond default rate seen through 2018, which tends to be a key indicator to BDC default rates. 

The decline in global junk bond defaults are expected to decline through mid-2018 due to low risk premiums on high-yield debt, steady U.S. economic growth and sufficient liquidity, according to Moody’s Investors Service.

The default rate on junk bonds fell to 3.1 percent in July from 3.2 percent in June. It is projected, 2017 ended at 2.7 percent and will decrease to 2.2 percent by July 2018, the rating agency said in a report. (Reporting by Richard Leong; Editing by Chizu Nomiyama)

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