High equity cushions should protect unsecured creditors in business development companies (BDCs) in case of a severe downturn, a stress-test by rating agency Moody’s has found.
Moody’s currently rates 34 BDCs, a majority of which are publicly traded and have a stable outlook.
“Our liquidity stress test indicates that most publicly traded BDCs would maintain adequate liquidity, with projected median 12-month liquidity coverage of 150 per cent, reflecting their good borrowing capacity and permanent equity,” it said.
However, while most individual BDCs are showing resilience, Moody’s overall outlook on the sector is negative. It justifies this position by pointing at publicly traded BDCs’ high leverage and recent redemptions in perpetual non-traded BDCs.
It argues that in a hard landing, “there would be material asset quality deterioration, capital erosion, funding disruption, and liquidity challenges”.
Its negative outlook is further substantiated by “developing asset quality risks from exposures to pre-rate-rise vintage loans and the software sector”.
Read more: Fitch Ratings warns of “deteriorating” sector outlook for US BDCs
While at the moment liquidity buffers look sound, Moody’s said creditor versus equity considerations could be tested in a steep decline, with tighter capital cushions reducing publicly traded BDCs’ ability to absorb losses.
It added that many BDCs have orientated their portfolio towards senior investments, which should alleviate portfolio declines in a downturn, but that a sustained severe scenario would still result in material markdowns, with rising asset risks.
In the first quarter of this year, investment valuations decreased but, according to Moody’s, still reflect fairly limited portfolio company deterioration and tight credit spreads.
