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Fitch renews warnings for BDC sector

The ratings agency reiterated its negative outlook for BDCs despite some positive developments reported during the first quarter.

Despite a modest reduction in average price-to-book ratio discounts during the first quarter, significant challenges and potential dividend cuts remain in the BDC sector, according to a statement released by Fitch. The statement said that while fee waivers had been used to relieve some of the pressure on dividends in the first quarter, this tactic would not be sustainable in the medium term.

The first quarter of 2016 saw a 0.45 percent average contraction in rated BDC portfolios on a sequential quarter basis according to Fitch, which highlighted many of the same issues facing BDCs in a report last month.

The rated peer group of BDCs examined by Fitch saw the average discount to net asset value decrease from 24.5 percent as of 5 February to 16.1 percent on 18 May. On recent earnings calls, some BDC executives expressed confusion about why their stock continued to trade below net asset value, while others highlighted steps taken to protect shareholder interests in light of discounts.

“There is a lot of discussion and skepticism about some BDCs’ portfolio valuations and how accurate they are,” said Fitch senior director Meghan Neenan in an interview. “There has been a big investor focus on CLO equity and some of the valuations of energy investments in particular. This is a very tight, small sector and there tends to just be some bleed-over from some of the bad actors and the good actors,” she added.

In its statement, Fitch said challenges facing the whole sector include capital constraints, low market volumes and risk of asset quality deterioration. The statement also noted a 109 bps increase in non-accruals in the first quarter over the previous quarter, reporting that non-accruals stood at 3.1 percent of average debt portfolios in the sector. This points to continued pressure on dividends, especially for BDCs with significant exposure to energy, according to Fitch.

Earlier this month, lower mid-market focused BDC Triangle Capital Corporation announced that it had reduced its dividend due to a decrease in net investment income, which has been harmed by a reduction in overall portfolio activity and related fee-related income for many BDCs.

On its earnings call last week, Apollo Investment Corporation chief executive officer Jim Zelter addressed an analyst’s question about the sustainability of its dividend, by saying: “We were always very focused on our dividend in terms of NII, which is what the industry is focused on, but we realised in a more volatile NAV environment, we might need to have a second look,” he said.  

Leverage is another key issue for the sector, according to Fitch, especially for BDCs with significant energy and related asset quality exposure. Average leverage for the group of companies examined by Fitch stood at 0.69x and the statement added that a recent focus on share repurchases across the sector had failed to improve leverage.

Fitch continues to expect some BDCs to divert portfolio payment proceeds into debt repayment to reduce leverage in [the] coming quarter. This should push sector leverage ratios modestly lower over the remainder of the year,” the statement said.