{"id":63061,"date":"2025-08-14T14:02:09","date_gmt":"2025-08-14T12:02:09","guid":{"rendered":"https:\/\/www.captrader.com\/?post_type=analyse&p=63061"},"modified":"2025-08-15T12:04:09","modified_gmt":"2025-08-15T10:04:09","slug":"bdcs-dividend-cover-and-the-interest-rate-turnaround","status":"publish","type":"analyse","link":"https:\/\/www.captrader.com\/en\/analyse\/bdcs-dividendendeckung-und-die-zinswende\/","title":{"rendered":"BDCs - dividend cover and the interest rate turnaround"},"content":{"rendered":"

For a change, today's article \"BDCs - dividend cover and the interest rate turnaround\" is not about Real Estate Investment Trusts (REITs)<\/a>but another interesting investment vehicle for income investors. Anglo-Saxon business development companies (or BDCs for short) have long been a favorite playground for this group of cash-flow-savvy investors. These types of investee companies provide debt and equity capital to mid-sized companies in the US and, due to their special regulatory status (Investment Company Act of 1940), do not have to pay corporate income tax as long as they distribute at least 90 % of their net taxable income. On the one hand, this structure leads to high and quite predictable dividends, on the other hand, BDC investors bear the credit risk of a potentially illiquid loan portfolio. In this article, I would therefore like to take a look at the current situation in the sector and highlight the effects of falling interest rates and explain them using examples.<\/p>\n\n\n\n

What exactly are BDCs?<\/strong><\/h2>\n\n\n\n

BDCs primarily finance private companies that are too small for the public bond market. The capital structure of the portfolios consists largely of senior, variable-rate loans (so-called first-lien loans) with short maturities. The borrowers pay a spread (typically SOFR<\/a> + 3-6 percentage points), so that the BDCs' interest margins increase when the short-term reference interest rate rises. However, many BDCs also make equity co-investments or subscribe to mezzanine capital. Due to this mix of loan and equity financing, BDC portfolios are not only sensitive to interest rates, but also exhibit a certain correlation to the economic environment.<\/p>\n\n\n\n

In order to mitigate the regulation somewhat, BDCs are allowed to increase their leverage ratio to a maximum of 2:1, i.e. they are allowed to use USD 2 of debt for every USD of equity. Many companies operate below this limit (they are then \"underleveraged\") and deliberately increase their debt when new investment opportunities arise. They may (theoretically) only pay dividends if the net investment income (NII), i.e. interest income less operating costs, is sufficient (dividend coverage). The risk\/return profile of the sector is based on this fact.<\/p>\n\n\n\n

Current situation and market environment<\/strong><\/h2>\n\n\n\n

A look at some research reports and articles on BDCs shows that we are dealing with a growing universe of business development companies. The assets under management of listed BDCs grew by a whopping 38% YoY in Q1 and an impressive 8% compared to the previous quarter. But you also have to look at the details. The \"heavyweights\" in the sector have only grown moderately, with the majority of growth coming from newly launched BDCs.<\/p>\n\n\n

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\"Bar
Growth in assets under management of BDCs<\/em>
(Source: lsta.org, BDC Quarterly Wrap: 1Q 2025<\/em>)<\/em><\/figcaption><\/figure>\n<\/div>\n\n\n

What is also noticeable is that the BDCs were still pulling hard on the levers as interest rates rose in 2023, but by the first quarter of 2025 the average net debt had fallen to 0.91\u00d7 (average of the largest BDCs: 1.01\u00d7). The companies are therefore operating below the legally permitted leverage.<\/p>\n\n\n\n

The portfolio composition continues to shift in favor of the somewhat safer first-lien loans, which now account for 86.4 % of the total portfolio, while the equity share has fallen to 7.1 %. <\/p>\n\n\n\n

As a risk-conscious investor, you should look at two key figures in addition to leverage: Non-Accruals and Payment-in-Kind (PIK) income. <\/p>\n\n\n\n

The average non-accrual ratio as at March 31, 2025 was 1.36 % of fair value. At the same time, the proportion of PIK income where the borrower does not pay in cash but pays elsewhere is increasing. The weighted average share of PIK income climbed from 6.22 % to 7.01 % of total interest income. Investors should keep an eye on this key figure, as a high PIK share can be a warning sign of deteriorating credit quality.<\/p>\n\n\n

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\"Bar
Rising payment-in-kind shares (Source: lsta.org, BDC Quarterly Wrap: 1Q 2025<\/em>)<\/em><\/em><\/figcaption><\/figure>\n<\/div>\n\n\n

This clearly shows that the PIK share has continued to rise in Q1 2025. Around 18 % of the BDCs examined even have a PIK share of over 10 %, which is a very critical development.<\/p>\n\n\n\n

Non-accruals in comparison<\/strong><\/h2>\n\n\n\n

The so-called non-accruals unfortunately require their own paragraph, as they are a critical cog in the dividend coverage wheel. Non-accruals measure the proportion of loans where interest or principal payments are at risk of defaulting or have defaulted (usually 60 days) and no more income is expected or can be recognized. The lower this figure, the higher the health of a BDC's portfolio. The following chart shows the non-accruals of some selected BDCs and the sector average.<\/p>\n\n\n

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\"Bar
Non-accruals of individual BDCs (source(s): Investor Relations of ARCC, FSK and OBDC)<\/em><\/figcaption><\/figure>\n<\/div>\n\n\n

While Blue Owl Capital Corp. (TWS ticker: OBDC, ISIN: US69121K1043) is well below the industry average (1.36 %) at 0.7 %, Ares Capital (TWS ticker: ARCC, ISIN: US04010L1035) still has a solid ratio of around 1.2 % despite a slight increase. FS KKR Capital (TWS ticker: FSK, ISIN: US3026352068), on the other hand, is well above average with non-accruals of 3.0 % (fair value) and 5.3 % (cost). A high value does not automatically mean that a dividend cut is imminent, but it does signal increased pressure on net investment income (NII).<\/p>\n\n\n\n

The interest rate turnaround and possible effects on BDCs<\/strong><\/h2>\n\n\n\n

BDCs benefit in times of rising interest rates as most of their loans have floating interest rates. In 2022 and 2023, floating spreads increased sharply, as BDCs had financed themselves at fixed interest rates and at the same time granted floating-rate loans, which ultimately caused the net investment income of many BDCs to literally explode and led to dividend increases and special dividends in many places. But what will happen when the US Federal Reserve (Fed) cuts interest rates in September?<\/p>\n\n\n\n