Gladstone Capital: Just a break for now (NASDAQ:GLAD)

Capital Gladstone (NASDAQ: HAPPY) is a BDC that has benefited substantially from rising interest rates. Approximately 94% of GLAD’s investment portfolio is comprised of variable rate investments that have seen steadily increasing net investment income (NII) for BDC amid a rising rate environment. However, this The higher rate environment is likely to end soon, with some rate cut increasingly likely. While these lower rates are likely to have a negative impact on NII, the dividend looks safe for now. However, BDCs high rating sees me rating GLAD as a hold for now.

Portfolio and risk management

Most BDCs provide some form of reporting on internal risk assessments for portfolio investments. Gladstone also reports on internal risk assessments. However, unlike other BDCs we’ve covered, such as Hercules Capital (HTGC) and The capital of the Trinity (TRIN), Gladstone does not provide detailed reporting on portfolio movements between different risk rating categories. Instead, Gladstone reports only the lowest risk rating assigned to any investment, the highest risk rating assigned, the average risk rating and the risk-weighted average rating of the portfolio as a whole.

While this is less valuable than the more detailed reporting provided by other BDCs, it still provides important insight into growing portfolio risk. In Gladstone’s latest 10Q report, the risk management system is explained:

The advisor uses a proprietary risk assessment system. Although the Adviser attempts to mirror the systems of NRSROs, we can provide no assurance that the Adviser’s risk rating system will provide the same risk rating as an NRSRO for these securities. The Adviser’s risk rating system is used to estimate the probability of default on the debt securities and the expected loss in the event of a default. The Adviser’s risk rating system uses a scale of 0 to >10, with >10 being the least likely to default. It is the Adviser’s understanding that most Lower Middle Market corporate debt securities do not exceed BBB on the NRSRO scale, so there would be no Lower Middle Market debt securities that meet the definition of AAA, AA or A. Therefore, the Adviser’s scale begins with designation >10 as the best risk rating that can be equivalent to a BBB from an NRSRO; however, no assurance can be given that a >10 on the Adviser’s scale equals a BBB or Baa2 on an NRSRO scale. The Adviser’s risk rating system covers both qualitative and quantitative aspects of the business and securities we hold.”

In the latest earnings report, the portfolio’s risk-weighted average rating improved from 7.5 in the previous quarter to 7.7. This is a promising development given that the persistently high rate environment has long been expected to pose a challenge for BDCs in terms of asset quality deterioration given the challenges some borrowers are facing in meeting their credit commitments . Fitch recently indicated that the BDC sector as a whole has faced increased asset quality risks in recent quarters.

According to Fitch, the BDC sector as a whole reported an average decline in net asset value (NAV) of approximately 0.7% and an average industry non-accrual rate of approximately 1.4% at fair value. In its most recent quarter, GLAD saw a 2% increase in NAV, which, while not particularly high, is slightly higher than the industry average. However, BDCs non-cumulative levels of approximately 2.1% of the portfolio are somewhat higher than the industry average.

Dividend safety

In recent months, several Seeking Alpha analysts have expressed concern about GLAD’s ability to maintain comfortable dividend coverage should interest rates fall. Gaming Dividend recently observed that “if interest rates are reduced and net investment income is adversely affected, there is a chance that the distribution can no longer be supported by GLAD’s portfolio investments.” These valid concerns stem from BDCs heavy reliance on floating rate investments which benefited significantly from the high interest rate environment.

However, as The Gaming Dividend also notes, there is little risk of a dividend cut in the immediate term given that the dividend is still comfortably covered by net investment income (NII). In its most recent quarter, BDC reported a dividend fully covered by NII, with an NII coverage ratio of approximately 111%. NII’s 1-year average coverage ratio is also around 107%, indicating that the dividend is still well covered.

However, investors should closely monitor rate developments, as faster-than-expected rate cuts could see GLAD’s NII drop substantially, given that more than 90% of its portfolio consists of variable rate investments. The current dividend may not be sustainable if interest rates fall significantly in the coming months. I currently do not expect a substantial rate cut in the near term, although some rate cuts are increasingly expected in the coming months. The Secured Overnight Financing Rate (SOFR), which is the rate used by GLAD to link interest rates to its portfolio, has already fallen from a 3-month high of around 5.4% at the end of June to around 5.34%.

ASSESSMENT

GLAD currently trades at a premium to NAV of just under 13%, which is the largest of the BDCs considered in the peer comp chart below. It is also broadly in line with BDCs Three-year average NPV premium of approximately 12.7%. However, in my view, the risk of the interest rate cut was not adequately assessed in the GLAD assessment.

The premium to NAV is much higher than that of BDCs that I believe are better positioned to maintain their dividends even in the event of a rate cut, such as Ares Capital (ARCC). Given this reality, I currently rate GLAD as a hold.

Conclusion

GLAD’s improvement in its portfolio’s risk-weighted average rating shows a positive development and signals that BDC may well maintain the low non-accrual levels currently reported. However, in my view, GLAD imposes a premium to NAV that is too high given the current risk of NII falling as interest rates fall. While the dividend is unlikely to be cut in the near term, BDC does not have a large cushion to maintain the dividend if rates fall faster than expected. With these factors in mind, I currently consider GLAD to be a hold.