The majority of BDCs are debt-focused, and thus invest most of their portfolios in corporate loans and debt to middle market and lower middle market companies. Therefore, credit spreads are very important to their business model.
When credit spreads are high, BDCs can generally deploy capital at higher rates. Their returns, net of investment losses, should be higher. When credit spreads are low, BDCs can generally deploy capital at lower rates, and earn lower returns net of losses.
BDCs and CCC credit spreads
CCC and below credits are those that are not investment grade. Therefore, these credits tend to look most like BDCs’ borrowers, who tend not to have a rating, or are rated below investment grade. Below is a chart from the Federal Reserve that shows CCC credit spreads since December 1996, the beginning of the data set.
This chart has some implications for BDCs:
- BDC share prices — BDCs are likely to trade at higher prices per share. As we write this in December 2016, BDCs are broadly trading near 52-week highs as credit spreads compress. Conversely, many BDCs made their recent 52-week lows when credit spreads widened in January and February of 2016.
- BDC underwriting — BDCs that have liquidity when credit spreads widen can capitalize on dislocation in credit markets. BDCs’ underwriting results were stellar during the 2010-2012 years in which capital was scarce and lenders could control the terms on loans.
- BDC leverage — BDCs are reliant on the capital markets to fund their balance sheets, and therefore, they are serial debt and equity issuers. When credit spreads widen, BDCs are less likely to be able to refinance their borrowings on favorable terms. Although they tend to widen and tighten in tandem, BBB and BB credit spreads may be more important to BDCs as debt issuers than CCC credit spreads. Generally speaking, investment-grade rated BDCs are usually in better position to raise capital than non-rated BDCs, but institutional demand for their bonds may dry up when spreads widen.