Dividend Coverage Levels

BDC Buzz
Feb 15, 2024
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Summary

  • This is a very in-depth report that will be referred to over the coming weeks/months comparing dividend coverage ranked by the 'worst-case' financial projections and the lower yield Leverage Analysis.

  • Also, we discuss PIK income categorizing each BDC based on the amount, quality, and trend/direction that has been added to the Google Sheets.

  • We have updated the Dividend Coverage Levels tables to take into account the recently updated projections for each BDC.

  • Please read if you are concerned about potential reductions in the current regular dividends due to the Fed cutting interest rates this year and/or increased credit portfolio issues.

  • Worst-case scenarios for each BDC include increased portfolio credit issues, lower NAV per share, declining portfolio yields (potentially from lower interest rates, as discussed below), higher borrowing rates and operating expenses, slower portfolio growth (or portfolio declines/repayments), and lower amounts of non-interest income (from fees and dividends).

To see the full Dividend Coverage Levels report, please use the following link:

BDC Dividend Coverage Levels Update

The following Dividend Coverage Levels reflect potential dividend coverage mostly ranked by using the ‘worst-case’ financial projections and the lower yield Leverage Analysis discussed in the Deep Dive Projection reports for each BDC. Worst-case scenarios for each BDC include increased portfolio credit issues, lower NAV per share, declining portfolio yields (potentially from lower interest rates, as discussed later), higher borrowing rates and operating expenses, slower portfolio growth (or portfolio declines/repayments), and lower amounts of non-interest income (from fees and dividends). Basically, the worst case is assuming a deeper and extended recessionary environment coupled with declining interest rates.

However, even if the underlying rates eventually go lower, there is a good chance that most BDCs will continue to over-earn their regular dividends. The following chart shows the average dividend coverage over the last 10 years with the last 5 quarters averaging over 120% even after taking into account the previous dividend increases. Many BDCs have opted to take a conservative approach when setting their regular dividends (just in case rates head lower) and are using supplemental/special dividends to pay out excess earnings. This means that if portfolio yields decline, we will see lower amounts of supplemental/special dividends but the regular dividends will be maintained especially ‘Level 1’ dividend coverage BDCs which are the ones that can cover their regular dividends by at least 90% using the lower-yield Leverage Analysis with a debt-to-equity ratio of 0.80.

The Fed funds target range declined by 2.25% (225 basis points) starting in Q3 2019 through Q1 2020 resulting in a decline in average dividend coverage from 109% to 102%. The only BDCs to cut their regular dividends were ‘Level 2’ except for GBDC which has subsequently increased it higher than the previous level (currently $0.39 per share compared to previously $0.33 per share).

ARCC management discussed this on previous calls and is “cautious about raising the dividend” and “chose not to raise the dividend because we'd like a stronger view on where we see rates normalizing in the future”.

Q. “Obviously dividend coverage is extremely strong here, 20% plus. I mean at what point do you kind of take it up another notch in terms of dividend increases? I mean, obviously, you have seen some great dividend increases over the last year. But with that view of no imminent recession, just how are you thinking about dividend levels given that level of dividend coverage?”

A. “I think the discussion that we had when we raised the dividend, obviously, was, the earnings are well in excess of given the raised dividend level, what's prudent, right? And the discussion that was much more about the direction of interest rates than it was about portfolio credit quality, right? So if we pull a couple of the different levers that could allow us to have a higher dividend or a lower dividend, the one that's the most impactful would be a significant decrease in base rates. You'd have to model non-accruals up a lot to have it to have any real impact on how we thought about the dividend today.”

“I don't know what the normal rate environment is going to be. I think we're working on an expectation that rates are elevated. They likely will go up from here. They likely will not stay there. We can all debate how long folks think they'll stay there or not, but our best guess would be that rates will normalize and begin coming back down. My own personal view is we're unlikely to see a 30 basis point LIBOR or SOFR again anytime soon. And that I think a lot of folks may look back is that potentially being a bit of a failed experiment. So our base case probably has rates down the line way out, normalizing down certainly from here, but my guess is as good as has as to where that is. It's been one of the reasons that we were cautious about raising the dividend as much as we did last quarter and frankly chose not to raise the dividend this quarter because we'd like a stronger view on where we see rates normalizing in the future.”

It is important to point out that lower rates have many benefits for BDCs including improved portfolio credit quality (lower payments and higher coverage ratios for portfolio companies), increased NAV per share, and lower yield expectations from investors resulting in BDCs heading back to LT targets, as discussed in the BDC Pricing & Market Update report.

Please note that if rates do head lower it could be excellent timing to refinance fixed-rate borrowings (many maturing 2025 through 2027) and/or benefit from lower borrowing rates on unused credit facilities with higher leverage. BDCs have many levers to pull to maintain or even increase dividends. Most BDCs are locking in new loans at higher rates with floors, and that might continue even if interest rates go down given the current market conditions including a “lender-friendly environment” with “higher overall yields”, better terms, and stronger covenants (safer investments) which are taken into account with the best-case projections. This is discussed in each of the Deep Dive reports including notes from the earnings calls.

Also, many BDCs achieve incremental returns with equity investments that are sold for realized gains often used to pay supplemental/special dividends. These BDCs include ARCC, GAIN, GLAD, FDUS, CSWC, PNNT, TPVG, HTGC, MAIN, and TSLX, as discussed in their reports.

BDC Interest Rate Sensitivity

Interest rate sensitivity refers to the change in earnings that may result from changes in interest rates. Most companies report interest rate risk/opportunity in the ‘Quantitative and Qualitative Disclosures About Market Risk’ section of the regulatory filings. FDUS discloses more than most BDCs as they include the potential incentive fees paid (or reduced) when estimating net investment income (“NII”). Most BDCs do NOT include this information but I have taken this into account for each BDC when calculating the potential impact on NII.

Almost every BDC carefully matches assets and liabilities, including floating or fixed rates, terms/durations, and risk profiles. The following items are some items to keep in mind:

  • Fixed-rate borrowings typically are at higher rates than variable-rate credit facilities

  • Credit facilities have unused line fees

  • New investments for most BDCs have been at higher yields

  • Most floating-rate investments have floors of 25 to 100 basis points

  • Some portfolio companies will prepay loans

  • Prepayments often drive fee income

  • Capital from prepayments is typically used to repay variable-rate credit facilities

  • Incentive fees need to be considered for both positive and negative impacts

There are plenty of other considerations but implying that the impact of rising/declining interest rates is not as straightforward as the Interest Rate Sensitivity Analysis shown next for FDUS and included in the Deep Dive Projection reports for each BDC.

FDUS Interest Rate Sensitivity Analysis

The following is from the previously updated FDUS Deep Dive Projection report and includes the information from the previously shown SEC filing.

As of September 30, 2023, 63% of FDUS’s portfolio investments bore interest at variable rates, and only 1% of its borrowings were at variable rates. If rates decline by 200 basis points, FDUS would likely cover its regular dividends by 127%. However, this analysis uses the NII per share over the last four quarters and most BDCs have had higher earnings over the last two quarters as their portfolio yields increased. FDUS’s portfolio yield has increased from 12.9% to 14.6 over the last four quarters and quarterly NII per share has increased from $0.51 to $0.68. The next table takes this into account and uses the average NII per share over the last two quarters.

Comparing the Impact of Lower Interest Rates on Dividend Coverage

The following table shows:

  • Last two quarters of NII (GSBD/TPVG exclude fee waivers, GAIN is four quarters)

  • Annual/quarterly impact from lower interest rates (100 /200 basis points)

  • Quarter earnings adjusted for lower interest rates (100/200 basis points)

  • Current regular quarterly dividends

  • Dividend coverage using earnings adjusted for lower interest rates (100/200 basis points)

To see the full Dividend Coverage Levels report, please use the following link: