Business development corporations are unlikely to lose their momentum in the near term, despite last week’s interest rate cut by the Federal Reserve and the ongoing trade conflict with China.
BDCs—the companies that invest in financially distressed small to medium-size private businesses—have yet to be affected by lower rates, which makes corporate bank debt cheaper for businesses to obtain. Cheaper bank loans have historically made the market more competitive for BDCs and other asset-based lenders.
Last Thursday, the Fed’s Federal Open Market Committee cut the federal funds rate to 2% from 2.25%, a move to help offset the slowing global economy and the escalating trade war with China. The president later in the day issued his latest trade salvo, announcing via tweet that the United States would issue 10% tariffs on an additional $300 million in Chinese goods, beginning on Sept. 1
The long-term trend of rising interest rates – from 1.441% in July 2016 to 3.0723% in May 2018 – has favored BDCs, and led to a surge in the Wells Fargo BDC Scorecard Weighted Index from 1,000 to 1,200 over that same period. As the U.S. economy expanded, so too, did BDC income. However, recent declines in interest rates toward the low 2.000s percentages has not inhibited BDC performance and the Wells Fargo index hit historical highs of 1,300 in July 2019.
BDCs’ performance not solely tied to interest rates
The resilience of BDCs against lower rates may be due to the fact that, unlike banks, BDCs’ results are not solely tied to net interest. BDCs generate a significant portion of their returns from realizations of portfolio investments. This puts them in a position to capture the rise in company valuations driven by market expectations for a sustained low interest rate environment. BDCs can also take equity positions in their underlying portfolio companies, either as direct investments or as warrants or other forms of equity kickers tied to debt arrangements. This participation in the low end of the capital structure provides a source of enhanced return that helps to keep the BDC proposition attractive even in a challenging interest rate environment.
The asset based lending industry has been experiencing a sea change over the past ten years with a new wave of independent non-bank ABLs emerging, resulting in more consolidations by national and regional banks proving strong ABL capabilities. As result, competition for high-yield loans has changed, as fewer banks exist. Over the last five years, the number of insured bank institutions has declined steadily, from roughly 6,600 in 2014 to 5,400 in 2019, according to Bloomberg.
However, the outlook for additional rate cuts by the Fed and global central banks, as well as moderating economic trends, will likely present challenging credit conditions for banks and BDCs alike.The downward shift and inversion in the yield curve could hamper asset yields.
BDCs may be preferable to other investment funds; unlike mutual funds and other open-end funds, BDCs provide the same liquidity to investors as other publicly traded investments.