December last year, I issued a bearish article on a rather popular BDC – Barings BDC (NYSE:NYSE:BBDC) – making the case that considering the underlying risks, the potential return profile is not strong enough to warrant an attractive investment play. After some while, BBDC circulated its Q4, 2023 earnings deck, which did not reveal any meaningful fundamental improvements for me to change the stance.

There are three main reasons why I consider BBDC a suboptimal choice:

1. Excessive leverage. Over the period of past 5 quarters, BBDC has registered a notable build-up of an external leverage, which has rendered the capital structure more indebted than sector average.
2. Weakening portfolio quality. On top of the increasing leverage component, BBDC has also recorded a growing non-accrual base, which raises concerns about the quality and financial health of the new investments that it has underwritten in order to growth the asset base. This in the context of a meaningful exposure outside the first lien structures makes BBDC’s profile quite risky.
3. Consequences from debt rollover. As of now BBDC is in a position to enjoy the benefit of an enticing spread capture due to its below average cost of debt that has been locked in before the SOFR started to go up. Yet, starting from 2025 these borrowings will begin to mature, thus triggering refinancings that will most likely (provided that SOFR does not meaningfully decrease) inflate the interest expense item.

With that being said, if we look at the YTD total return performance chart comparing BBDC with the sector index, we will notice that Barings has outperformed the benchmark by a huge margin.

Given the aforementioned dynamics (i.e., subpar fundamentals but well-performing stock price) and the fact that BBDC has just recently issued its Q1, 2024 earnings deck, it is worth revisiting my previous thesis to understand whether there are any notable changes that could justify a buy rating here.

Thesis review

The Q1, 2024 period was quite successful for Barings and some of the data points indicate that certain risk aspects have decreased in the system. Yet, there are also a couple of items, which imply that there are still some risk exposures remaining open that could potentially magnify the downside risk in case the overall economy (and BDC business) turns south.

Let’s start with the positives.

First, the the NAV per share ticked higher due to several successful equity investment sales that contributed to a net income per share of $0.41, which is by ~60% above the result in the prior quarter. Since the quarterly dividend is still at $0.26 per share, the remaining chunk of value stayed in the books, thereby strengthening the NAV base.

Second, the non-accrual component improved a lot during the quarter, allowing BBDC to close Q1 at the lowest level in non-accrual reserves measured over the trailing 5 quarter period. Namely, the non-accrual position decreased from 1.5% of total portfolio FV in Q4, 2023 to 0.3% of the portfolio FV as of March 31, 2024. This sends a strong message about the strengths of the embedded investment quality in BBDC’s portfolio.

Third, during the quarter Barings was able to further expand its portfolio by $23 million (on a net basis), where the gross fundings came in at $142 million offsetting the $119 million of organic repayments. Having larger asset base inevitably helps keep the net investment income protected from margin compression and makes it easier for the Management to increase the result.

In this regard, it was also encouraging to hear the commentary by Matt Freund (President) in the recent earnings call, where it was nicely outlined that the near-term prospects on the net funding end remain positive:

Activity broadly remained tempered during the quarter, but directionally comparable to the immediately preceding quarters. Much unchanged from last quarter, and based on recent conversations, investment bankers have reiterated their expectation that LBO activity is expected to meaningfully increase in the quarters to come. Our sponsor issuer clients have expressed the same anticipated uptick in transactions. However, while we have seen an uptick in the number of early stage opportunities, the conversion rates to closed transactions are trending towards historic lows.

However, turning to the negatives, I have to underscore also three distinct aspects, which to some extent offset the benefits or positives stemming from the aforementioned elements.

First, while the net income per share did indeed surge higher as outlined above, the net investment income, which is a better measure for reflecting the underlying cash generation profile, actually came in lower than in the prior quarter. We can see in the table below a nice breakdown of the major components driving the net investment income, but the key ones to highlight are lower interest income and dividend income figures. Besides the worsened performance within BBDC’s equity investment category (which lead to lower dividend income), the interest income is a notable area of concern that has dropped despite the uptick in BBDC’s portfolio size and a better non-accrual profile. Unfortunately, the driver here is structural, which is not that easy to avoid – i.e., the overall spread compression in the BDC space.

Second, despite shrinking net investment income, BBDC’s leverage continued to tick higher, reaching 1.21x of debt to EBITDA (and 1.17x of net debt to EBITDA), which is above the sector average. This is not a great sign, especially against the backdrop of weakened cash generation profile.

Third, while the non-accrual position has gone down (which is a very solid dynamic), the remaining portfolio has actually become less safe compared to Q4, 2023.

In other words, the internal risk rating categories 4 and 5 which indicate that these positions are performing below expectations have both taken larger share of the total portfolio exposure. This means that there is just a higher sensitivity to any headwinds around the corporate distress and, in general, higher embedded probability of the Management being forced to recognize new non-accruals.

The bottom line

In a nutshell, Q1, 2024 earnings report revealed some encouraging signs and some elements that offset these positives. On the one hand, BBDC managed to deliver great results from its equity portfolio, making enticing exits on top of improving non-accrual balance. On the other hand, the key metric (i.e., net investment income) dropped, leaving a very tiny margin in place for covering the existing dividend – with a dividend coverage of just ~107%. Plus, if we peel back the onion a bit, we will notice that the changes in internal risk ratings have actually increased the probability of recording new non-accrual going forward.

As a result of this, I still do not see a sufficient basis for going long Barings now.