Are rate cuts bad news for BIZD ETF?

The Federal Reserve is expected to cut interest rates this month and make further cuts in the coming months. In fact, the market believes there is a greater than 50% chance the Fed will taper 125 basis points by the end of the year. This is a significant reduction in interest rates for a period of just four months, which could have a substantial impact on securities whose yields are linked to short-term interest rates. As a result, the business development company (i.e., BDC) sector is particularly at risk, as many BDCs are slated to face more than 10% reductions in their net investment income should the Fed reduce rates by 100 basis points.

With this in mind, we will take a look at VanEck BDC Income ETF (NYSEARCA:BIZD) to determine if rate cuts are likely to provide a significant headwind for it.

BIZD Holdings

Before looking at rate cuts, we need to look at the top holdings in BIZD. A quick look at its top 10 holdings shows that the fund is heavily dominated by Ares Capital Corporation (ARCC), with 21.52% of its portfolio allocated to this BDC. Overall, despite having 26 total positions, the top 10 holdings account for 72.41% of the ETF. This makes it very difficult, with FS KKR Capital Corporation (FSK) taking another 9.42%, Blue Owl Capital Corporation (OBDC) taking 9.1%, Blackstone Secured Lending Fund (BXSL) taking 8.26% and Main Street Capital Corporation (MAIN) rounding out the top five with an exposure of 4.81%. Other top holdings include Hercules Capital (HTGC) at 4.56%, Golub Capital (GBDC) at 4.46%, Sixth Street Specialty Lending (TSLX) at 3.91%, Morgan Stanley Direct Lending Fund (MSDL) at 3 .19% and Prospect Capital Corporation (PSEC) rounding out the top ten with an exposure of 3.17%.

The impact of the rate cut

To determine the impact that interest rate cuts will have on this ETF, we need to analyze the interest rate sensitivities of these firms based on the current interest rate sensitivities reported in their respective 10-Qs. Ares Capital Corporation will see a 7.5% gain in net investment income for every 100 basis points the Federal Reserve cuts. FS KKR Capital Corporation will experience a similar effect, with a 7.5% reduction in net investment income for every 100 basis points the Fed cuts rates. Blue Owl Capital Corporation has slightly higher interest rate exposure, with net investment income likely to decline by about 9% for every 100 basis points the Fed cuts. The Blackstone Secured Lending Fund is facing even more trouble due to lower interest rates, with an 11.5% cut for every 100 basis points. Main Street Capital Corporation will see net investment income fall by just 4.3%, while Hercules Capital will experience a 5.8% headwind for every 100 basis points the Fed cuts. Golub Capital BDC will face an 11.5% discount and the Morgan Stanley Direct Lending Fund will face an 11.3% discount. Sixth Street Specialty Lending will see a 6% impact and Prospect Capital will see an 8.6% decline in net investment income from a 100 basis point cut.

What this shows is that while there are a few firms – such as MAIN, HTGC and TSLX – that will not see a significant headwind from the interest rate cut, many will be significantly impacted. Therefore, while interest rate cuts should help stabilize underlying loan performance by reducing pressures on BDC counterparties’ balance sheets, thereby reducing non-accruals, they will still present a significant headwind to the earning power of the funds’ underlying holdings. In addition, it is likely to reduce additional distributions from these BDCs and potentially even threaten some of their regular dividends.

However, ARCC, FSK, OBDC, BXSL, MAIN, HTGC, GBDC, TSLX and MSDL all have enough coverage of their regular dividends that a cut of just 100 basis points or even 125 basis points by The Fed is unlikely to threaten their regular dividends. . However, if interest rate cuts go much deeper next year, especially if they are accompanied by a recession, some of those dividends could start to be challenged. The only one in the top ten at risk of a significant short-term dividend cut is Prospect Capital ( PSEC ), which represents 3.17% of the total portfolio.

Investor Takeaway

In conclusion, the BIZD is not too threatened by at least a mild set of rate cuts from the Federal Reserve. That said, its total dividend payments will likely decline as a result of a reduction in special distributions from its underlying holdings that will progress as dividend cuts begin to affect their net investment income levels. Therefore, investors holding BIZD should expect a lower dividend yield in the future. Additionally, if rate cuts become much deeper and/or a recession hits, BIZD will likely experience a loss in NPV due to a decline in the valuations of its underlying BDCs and/or a decline in the underlying net asset values. Thus, while the initial wave of dividend cuts is only a minor headwind and should not be seen as a significant threat, significant interest rate cuts and/or an economic downturn would be very bad news indeed for BIZD .

Accordingly, we believe it is prudent to underweight the BDC sector, including a holding in BIZD, for the foreseeable future until more clarity is achieved on macroeconomic conditions. This is especially true given that the BDC sector is quite richly valued at the moment, with many BDCs – such as ARCC, MAIN and others – trading at premiums to both underlying and average NPVs their rating history.