A growing rift is emerging in high-yield stocks, specifically business development companies. In the past few months, many of the industry's biggest names have taken a dive as investors re-evaluate their willingness to accept higher risks for higher yields.
The chart below shows the movement in select BDC stocks over the past three months:
What explains the discrepancy between these companies' recent share price moves? After all, these companies share similar business models and, arguably, similar risk exposures. They are all largely invested in the debt of private companies.
Looking at the chart, I noticed a few trends.
Dividend coverage
All of the BDCs that have largely held their own in the last few months are more than covering their dividends with net investment income. While no financial metric is perfect, net investment income is a good proxy for a BDC's ability to pay existing dividends on an ongoing basis.
Going forward, I'm almost certain the best performers will be those whose regular dividends are best covered by net investment income. As the underlying investment yields in a BDC's portfolio deteriorate, investors will be willing to pay more for companies that have fewer question marks surrounding their payouts to shareholders.
Management teams
The BDCs that weathered the 2008 downturn, or have significant human capital, are doing just fine. FS Investment (NYSE: FSIC), which is managed by GSO Blackstone, and Golub Capital BDC (GBDC -0.81%), which is managed by one of the biggest arrangers in the middle market, have the reputational capacity to hold up the share price despite their post-financial-crisis IPO dates.
The share price for any given BDC is a reflection not only of the BDC's operational performance, but also of investor confidence in a BDC's management team. GSO Blackstone and Golub Capital, which are big players in private finance, have arguably better managers, and better deal flow, than your average BDC.
Aligned incentives
Notably, the BDCs with the lowest expense ratios and shareholder-friendly fee structures are holding up fine. Ares Capital Corporation (ARCC 0.24%) is a sole exception to this rule. Ares gets a lot of credit -- and it should -- for surviving and thriving through the Great Recession, in which many of its peers lost a third or more of their book value.
It's a simple fact that the newest BDCs have some of the best fee structures and alignment of interests between managers and shareholders. Newer BDCs, although they may lack a historical record, are rightfully getting credit for the fact that managers have an incentive to think like long-term investors.
Beyond the portfolio
You can't make a strong connection between particular investments and a BDC's recent performance. There are good and bad performers who use more leverage, as well as good and bad performers who use long-term capital or who have access to cheap capital from the Small Business Administration.
Likewise, this recent share-price dip isn't a simple correction based on valuations. Main Street Capital (MAIN 0.23%) enjoys one of the loftiest price-to-net-investment-income ratios of any BDC on this list, yet its above-average valuation hasn't been shaken. Similarly, the BDCs with the lowest price-to-NII ratios have remained in the low-valuation camp.
And while tax-loss selling may play a part, I'd be more inclined to believe that was the main catalyst if not for the fact that all BDCs -- even those that have held up throughout most of the year -- were down modestly in the most recent week leading up to today. Tax-loss harvesting may motivate investors to sell, but the real question is whether they will return to the same stocks. I think not.
After years of a market environment where virtually any middle-market lender could make money, investors seem to be rethinking whether or not they're comfortable with the same managers in a downturn as they were in an upturn. It's a question any BDC investor should be asking, because, in the end, it's all about the jockey.
