Hi YXI friends,

As all the earnings results have come to a close for the quarter ending on September 30th, we are going to do a holistic review across all 13 of the BDCs under our coverage. This article is designed so that someone with no prior knowledge of BDCs can quickly understand the key advantages and risks involved.

There are two purposes of this article. Firstly, we establish a quarterly dashboard or “cheatsheet” for evaluating the BDCs, in terms of their profiles and performances. Secondly, we compare all the BDCs to find red flags and green flags, so there are a lot of clues beyond just the premiums and dividend yields for the best potential picks.

The output should look simple, with tables and charts, but it is the result of carefully reviewing all of the financials, 10Qs, and transcripts of the 13 BDCs from the past quarter.

We do have a summary of the top five BDCs at the bottom for those who only want a quick glance.

Let’s begin!

DISCLAIMER: This newsletter is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.

1. Why Invest In BDCs In Today’s Environment?

BDCs are private credit vehicles that provide a high yield with tradable market liquidity. This means instead of getting 4.5% on US Treasuries, you can collect more than double the yield from BDCs. Even better, you can trade in and out of the market, selling shares as the prices appreciate and buying when the prices dip.

BDCs are effectively a yield arbitrage between cheaper debt borrowed by the BDCs themselves as public vehicles and the high-yielding debt borrowed by the portfolio companies who have less access to credit.

The BDCs that are rated at BBB or BB only have to pay an extra 1 or 2% to borrow money. However, they can get a juicy return on their less credit-worthy investments at 11%+.

Private companies are inherently less mature and more risky than public companies, and therefore demand a higher risk premium. If the borrower company’s underlying business runs into trouble, they could more easily default on the debt. In comparison, a public company can issue more debt or equity in the secondary market.

BDCs try to reduce the riskiness of their portfolio through 1) skilled due diligence (don’t laugh) and 2) immense diversification. Here, the size of the BDC does have an advantage. Here, size does matter. A bigger fund (or one that shares a big PE platform) with more gunpowder can afford a bigger team to build bigger deal pipelines, review more deals, and access more corners of the private lending market.

However, there are also limits to this “yield arbitrage” (in truth, it’s not really an arbitrage, because it’s not risk-free).

First, the returns are significantly subject to the overall macro environment. As the Fed raises rates, BDCs can gain higher returns (nearly all of the incomes are floating rates) from portfolio companies, but the risk of non-accruals (meaning a company unable to pay back) also rises. Therefore, what we really want is a moderately high rate environment on the back of strong economic growth. Sounds like today’s environment? That’s right.

Secondly, the returns are subject to the overall credit market tightness, which can actually fluctuate a lot. Recently, BDCs have reported greater competition in the lending market with tightening credit spreads in a strong economic context. We can approximate the changing dynamics of the private credit spread using CCC Corporate Spread provided by FRED. A tight credit spread is unfavourable for BDC returns, although it indicates positive health and high investor demand in the lending sector.

Thirdly, diversification does not necessarily mean risk free. There is still an underlying correlation between the borrowers as they are nearly all in the US. A big recessionary hurricane can capsize all boats, as it did in 2007 for housing.

Finally, the private credit market is nowhere near as transparent as the public markets. The “fair values” marked by the BDCs on their hundreds of investments are all internally assessed, with significant room for valuation adjustments from period to period. This creates opportunities for management to massage their net income figures and produce pleasantly smooth returns. Therefore, we have to keep a keen eye on the realised & unrealised losses as well as non-accruals.

2. BDC Risk Profiles - Portfolio Diversification, Secured Lending, and Non-accruals

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