The continued recovery in portfolio valuations for business development companies (BDCs), given the improving U.S. economic outlook and vaccine rollout, support their credit profiles, Fitch Ratings says. However, cash earnings and coverage of dividends are expected to remain pressured in 2021, as competition drives pricing back to pre-coronavirus levels and repayment activity remains elevated.
Net unrealized appreciation in 1Q21 averaged 1.5% of rated BDCs’ YE20 portfolios versus 7.1% depreciation in 1Q20, reflecting reversals of pandemic-driven markdowns. Non-accrual metrics have largely stabilized but remain elevated for some, which could translate into higher realized losses. Still, portfolio credit performance has outperformed expectations, likely contributing to a recovery in BDC stocks since the depths of the pandemic.
Asset coverage cushions have benefited from valuation trends, averaging 28% for the rated peer group in 1Q21 versus 19.9% at 1Q20, at the upper-end of Fitch’s ‘bbb’ category benchmark range of 11%-33%.
Cash earnings are expected to remain pressured by lower interest rates, competitive pricing, higher non-accrual investments, increased PIK income, and higher repayment activity, which will challenge some BDCs from improving near-term dividend coverage. Net investment income coverage of dividends averaged 101.3% in 1Q21 versus 108.7% for 2020, with several BDCs’ dividend coverage below 100%.
PIK levels remain elevated from covenant amendments that spiked in 2Q20, which were often in exchange for sponsors injecting additional capital into portfolio companies amid the market dislocation. While amendments have declined meaningfully, those still in place could just delay, or even exacerbate, inevitable losses. PIK income averaged 7.6% of total interest and dividend income for 1Q21 versus 5.3% a year ago.
BDCs with higher leverage or lower covenant cushions could face downside ratings risk should coverage cushions fall below Fitch’s benchmark levels or realized losses meaningfully increase. Average regulatory leverage was stable at 0.91x in 1Q21 and generally below targeted levels of 1.0x–1.25x.
