Building an Olive Orchard with BDCs

Rarely does one plant an orchard and expect to become rich immediately. The average fruit tree can take four years to start bearing fruit. It can take another five to six years for that fruit tree to have a sustainable and consistent level of production.

If you want to have a type of orchard that takes forever to get going, you start planting olive trees. While olive trees can start fruiting between the first three to five years after planting, it can take up to 65 or even 80 years for an orchard of olive trees to have a consistent, sustainable yield. Because of this extremely slow growth rate and stabilization, an olive tree can produce fruit for over 1,000 years.

With Easter just passed, The Garden of Gethsemane, a well-known location in Christianity, remains present today. If you were to travel to Israel, the Garden of Gethsemane is an olive orchard where olives were grown and then pressed to make olive oil. There are still trees present that have been there for thousands of years.

When I'm building a portfolio for my retirement, I'm not trying to build a portfolio that's made up of strawberry plants – where I plant them, they produce something right away, and they wither or disappear. I'm not making a portfolio of cucumbers that last for 90 days from when you plant them until when they start withering and dying. I want a portfolio that's going to weather the storms of life, that's going to produce what I need. While my portfolio ideally won't take 65 to 80 years to diminish the sustainable yield, I don't need it to last 1,000 years either.

I build my portfolio to provide for my needs as I look forward, continue to grow in income, and produce what I need. My portfolio is an orchard of trees of many different types, producing different yields, but all providing me with a cash crop that I can live on. I don't hack down the trees when times get rough. I might prune trees here and there – take off dead branches or diseased branches – and I might even remove a tree if it's dying or dead, but my overall goal for my orchard of a portfolio is to collect what it produces and leave the trees alone.

In recent weeks, we've seen multiple companies get severely battered and beaten due to the uncertainty surrounding global trade and the economy. Today, I want to take a moment to ride the waves of tariffs and explore some investments that can provide you with a great income over the long run. These investments have been producing income for decades, so you can readily expect them to continue doing so.

"Be fearful when others are greedy, and greedy when others are fearful." — Warren Buffett

If you've been watching your portfolio lately with one eye covered (don't worry, we all do it!!!), you've probably noticed the market throwing quite the temper tantrum. While many investors are panic-selling faster than tickets to a Taylor Swift concert, we at Dividend Dynamo have been doing something that might seem counterintuitive — we've been buying Business Development Companies (BDCs) with both hands.

Let's dive in!

Why We're Swimming Against the Current

The recent market volatility has created what I like to call a "logic-free zone" in BDC valuations. When the S&P sneezes, BDCs catch pneumonia — at least in terms of share price. But here's the fascinating part: this price action has almost nothing to do with the actual performance of these companies' loan portfolios.

While BDC share prices have tumbled 15-20% from their peaks, their underlying Net Asset Values (NAVs) are expected to remain relatively stable when Q1 reports come out. In other words, we're seeing a massive sentiment-driven discount on fundamentally sound assets.

Our Prime Targetsin the Last Weeks: BXSL and MSDL

We've been particularly keen on adding two blue-chip BDCs to our portfolio: Blackstone Secured Lending (BXSL) and Morgan Stanley Direct Lending (MSDL). Let me tell you why:

BXSL: The Blackstone Bargain

Blackstone Secured Lending isn't just any BDC — it's backed by Blackstone, one of the world's premier alternative asset managers. When we look at BXSL's performance metrics, it's clear why we've been buyers at recent discounted prices.

What makes BXSL a standout choice for stability and security?

• Superior Interest Coverage: BXSL's portfolio companies maintain a 1.7x LTM EBITDA interest coverage ratio, significantly better than the broader private credit market average of 1.5x. Only 9% of BXSL's portfolio, by fair value, shows interest coverage below 1x, compared to 15% for the broader private credit market.

• Exceptional Credit Quality: With non-accruals at just 0.3% of cost compared to the BDC peer average of 2.6%, BXSL's credit selection process is working. Their watch list of at-risk investments is also lower than most peers.

• Defensive Positioning Against Tariffs: Management has conducted an extensive analysis of potential tariff impacts and estimates only a "mid-single digits" type of exposure for companies that might be affected by tariffs from regions like Mexico, China, and Canada.

• Consistent NAV Performance: BXSL has demonstrated impressive NAV per share stability over multiple periods, with 5-year NAV growth of 8.2% compared to a peer average of -7%.

MSDL: Morgan Stanley's Money Machine

Morgan Stanley Direct Lending brings the institutional expertise of another Wall Street heavyweight to the business development company (BDC) space. At the right price, MSDL offers an impressive combination of yield and safety that's hard to match.

What makes MSDL particularly compelling for stability-focused investors:

• Premium Credit Quality: With 97% of investments in first-lien senior secured debt and non-accruals accounting for just 0.2% of fair value, MSDL maintains one of the highest-quality portfolios in the sector.

• Conservative Watch List: Only 8.6% of the portfolio at cost is on the watch list, significantly lower than most BDC peers, suggesting fewer potential problem loans on the horizon.

• Superior Diversification: MSDL's highly diversified portfolio features an average investment size of just 0.5%, with the top 10 positions accounting for only about 16% of the portfolio. This reduces concentration risk dramatically.

• Strong Dividend Coverage and Surplus Income: With excellent dividend coverage (as shown in the metrics chart) and $0.78 per share of undistributed taxable income ("spillover"), MSDL's distributions are well-protected. The company has already announced special distributions of $0.20 per share for 2024, with additional special dividends likely in 2025.

• Prudent Management Approach: MSDL actively repurchases shares when the price is below NAV and maintains a strong balance sheet, with 53% unsecured borrowings and investment-grade ratings from both Moody's and Fitch.

Why BDCs Instead of CEFs Right Now?

You might wonder why we're focusing on BDCs rather than Closed-End Funds (CEFs). Here's our reasoning:

1. Valuation Gap: BDCs recently hit median discounts of around 20% to NAV, compared to just 7% for CEFs. Even accounting for potential Q1 NAV adjustments, BDCs represent much better value.

2. NAV Stability: The median 3-year NAV change for BDCs is significantly better than for credit-focused CEFs. While top-tier BDCs like BXSL have maintained or grown their NAVs, even well-regarded CEFs have seen NAV erosion. (Let me know if you want to learn more about this analysis!)

3. Distribution Sustainability: BDCs tend to under-distribute income due to regulatory reasons, while CEFs often over-distribute. This makes BDC dividends generally more sustainable over time.

4. Higher Returns: Both total returns and current yields favor BDCs in the current environment.

Our Countercyclical Strategy in Action

This isn't our first rodeo. Our countercyclical approach to investing means we reduce exposure to higher-risk assets when valuations become frothy and add to them when they become more affordable. The current market panic has created precisely the kind of opportunity we've been waiting for. And we use our ‘Barbell strategy’ to load up when we can!

Remember how we trimmed our BDC exposure last year when everyone was piling in? Now we're doing the opposite, adding quality BDCs at significant discounts while others flee in terror.

What About the Risks?

Let's not pretend there aren't risks. The primary concern is the potential for stagflation, which is characterized by higher inflation and lower growth, partly driven by tariff policies. This could pressure both interest coverage and earnings for BDC borrowers.

It's important to note that even quality BDCs, like our favorites, have specific risk factors:

For MSDL:

• Management and incentive fees will increase starting January 2025

• Some watch list concerns include 48Forty Solutions (recently marked down in Q4), Continental Battery, and Help/Systems

• It’s relatively new portfolio (9% maturing before 2027) hasn't been fully tested through a credit cycle

For BXSL:

• While its watch list is smaller than peers, the company still monitors portfolio investments that could face pressure

• Some exposure exists to potential tariff impacts, though management estimates this at only mid-single digits

However, the key to our strategy is buying at the right price. When we can purchase these blue-chip BDCs at 15-20% discounts on NAV, we create a significant margin of safety. These discounts effectively price in many of these risks, giving us both downside protection and the potential for price appreciation when market sentiment improves.

Our Game Plan Going Forward

Just as a patient orchardist doesn't uproot trees during a storm, we're not abandoning our strategy at the first sign of market turbulence. These volatile periods are precisely when we can add quality income-producing "trees" to our orchard at discounted prices.

While we've been active buyers in recent weeks, we're not chasing prices higher from here. The sector has already bounced somewhat from its lows, and we expect more volatility ahead. We'll be patient and opportunistic, looking to take advantage of any significant pullbacks.

For now, we're content with the significant yield boost these additions have provided to our portfolio. Both BXSL and MSDL are delivering double-digit yields based on their net investment income, and we've locked in these yields at attractive entry points.

Remember that our portfolio is designed to be a diverse orchard of income-producing assets. We don't hack down our trees when times get rough, we might prune here and there, but our goal is to collect what our orchard produces and let it grow. BDCs like BXSL and MSDL, purchased at the best prices, can be those reliable olive trees in your portfolio; perhaps not the flashiest investment, but capable of producing income for decades. For your family. For … decades …

As always, we remain committed to our disciplined approach: buying quality income investments when others are fearful, and taking profits when optimism returns. It's not always comfortable being a contrarian, but like tending an orchard, patience and a long-term perspective are often rewarded.

Until next time, keep nurturing your dividend orchard!

Your Patient Income Gardener,

Professor Lincoln C. Wood.