2Q23 Preview | Business Development Companies Tailwinds from Higher Base Rates to Boost NII as NAVs Set for Modest Expansion in 2Q

BDC shares have performed well YTD, both on an absolute and relative basis (vs. the S&P 500 Index) as multiples have expanded on improved investor sentiment. The tailwinds from higher benchmark interest rates have persisted through 1H23 (and our estimates reflect further benefits from rates expected to peak in 2H23) and credit pressures / defaults appear to have remained muted thus far with only a modest increase in non-accrual rates as inflationary pressures on borrowers have begun to stabilize.

P/NAV multiples across our coverage have expanded toward the mid-high end of their respective TTM ranges, reflecting improved investor sentiment as higher base rates have boosted earnings power. Though investors have been weary of potential credit deterioration for the last several quarters, non-accrual rates have remained relatively low.

We believe there are pockets of opportunity for multiple expansion for those BDCs that prove resilient (peer-leading ROEs, solid underwriting, and relative NAV stability). However, we remain cautious about potential downside volatility in P/NAV multiples should the credit environment deteriorate more rapidly. According to data from our J.P. Morgan High Yield team, leveraged loan and high-yield defaults increased by ~53bps Q/Q in 2Q23 to 2.0%, but still well below the long-term average of 3.0%.

We currently estimate an average of 25bps of Q/Q non-accrual rate increases in 2Q, followed by 50bps quarterly in 2H23, and then decelerating increases/non-accrual peaks in mid-2024.

Our estimates have continued to increase, driven by the impact of changes in interest rate expectations (as indicated by the forward rate curve) that have continued to shift in favor of a “higher for longer” scenario. The chart below shows the evolution of the 3- month SOFR forward rate curve at various points in 2023. Compared to expectations toward the beginning of the calendar year, current expectations indicate interest rates ~90bps higher at YE2023 and YE2024 and ~50bps higher at YE2025.

Spreads were stable - narrower in the June quarter with spreads on BB/BB- widening 2bps sequentially to L+330.3 (vs. L+328.1 in March) and spreads on B+/B narrowed 48bps to L+489.7 in June (vs. L+538.0 in March).

Our analysis suggests that NAVs will be modestly higher (~1.0% on average across our coverage universe) on a Q/Q basis in 2Q, driven by a combination of NII profiles out-earning BDC dividend levels and spread tightening during the June quarter. We expect the impact of spread tightening will drive mark-to-market values modestly higher and in excess of the impact we expect from a gradual, continued normalization in credit.

Headed into 2Q, BDC portfolio leverage levels are generally towards the middle of mgmt teams’ respective target ranges with a few exceptions. Given muted deal activity and a slow issuance environment that persisted from 1Q into 2Q, we have modeled relatively lower capital deployment and borrower repayments / exits for 2Q versus prior year periods. We also anticipate a patient approach from mgmt teams regarding increasing portfolio leverage. While we have heard for several quarters that deal terms and pricing are increasingly attractive, we note that mgmt teams have kept some dry powder, particularly as higher base rates are driving NII profiles higher and providing substantial dividend coverage. We believe elevated earnings will persist through 2H23 based on the forward interest rate curve; we anticipate mgmt teams may remain patient on portfolio leverage and keep some dry powder to weather any future increase in volatility.

Leveraged loan issuance has fallen to the lowest levels since the Great Financial Crisis YTD in 2023. This follows a post-COVID spike in issuance in 2021 to $789B as companies rushed to issue floating rate debt in accommodating capital markets, then declined to $435B in 2022 amid greater uncertainty and more stringent pricing and terms. 1H23 leveraged loan issuance totaled $148B (down from $214B Y/Y). Middle market issuance trends have similarly declined, with $0.9B of issuance in 1H23 compared to $3.6B in 1H22.