Today's economic conditions are attractive for BDCs (business development companies), and some benefit from businesses seeking alternative financing sources.
- As banks tighten lending standards, more companies are turning to BDCs for financing.
- BDCs that focus on smaller and technology-oriented companies are seeing a meaningful increase in their opportunity set.
- The economic environment supports high interest rates and low default rates — a compelling combination for BDCs.
As the Federal Reserve has tightened interest rates over the past 18 months, banks have tightened lending standards. Many BDCs are poised to fill this gap in credit markets. In particular, BDCs that specialize in serving smaller and middle market companies ($50M or less in EBITDA) are benefiting, as are those with a focus on technology companies. The collapse of Silicon Valley Bank in March 2023 was a key turning point for these segments, in our view, spurring a growing number of small and tech-oriented companies to consider BDCs as a source of financing.
Putnam BDC Income ETF (PBDC) can take advantage of this potential growth opportunity. With an active strategy, we can build an attractive level of exposure to this emerging trend. Individual BDCs might be over- or underexposed to smaller companies and the technology sector. We can actively position the ETF in several BDCs to gain exposure to areas of the market with compelling opportunities.
Outlook on the BDC landscape and the economy
While we see challenging economic conditions ahead, this may also be favorable for BDCs. The economy continues to slow gradually under the Federal Reserve's hawkish interest-rate policy. We believe interest rates might rise even more and stay at a high level for a considerable period. This upward bias to rates continues to directly drive BDC profitability and, hence, near-term shareholder dividends.
Meanwhile, we are concerned that the bank liquidity crisis, the drawdown of consumer savings built up during past government stimulus, and the impending resumption of college loan payments together pose a risk of recession in the near term. However, if the economy can muddle along, remaining lackluster but without contracting, it should provide enough momentum to keep loan default rates reasonable. The 10% yields available from BDCs would be attractive when compared with small- and mid-cap equity market returns.
If a recession happens in 2024, it could adversely affect BDCs along with the broader equity markets, in our view. Losses on loans could be a problem for BDCs. However, we believe our active approach to investing can uncover companies that have already evolved their lending and borrowing practices to mitigate the risk of book value destruction through losses on their loans. Amid these economic conditions, we will continue focusing on more defensive strategies relative to the fund's benchmark.
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