Three fictional BDCs, one income stack each, and the leverage that makes a high dividend yield the one the income does not pay.
BDC dividend coverage is net investment income per share divided by the dividend per share for the same period. Build NII from the income stack: asset yield on gross assets, less interest on the debt, the base fee on gross assets, other expenses and the incentive fee. For the fictional Corlett Credit, a BDC displaying a 14.67 per cent dividend yield, that gives 0.3005 of NII against a 0.33 dividend, a coverage of 91.1 per cent: the dividend is being paid partly out of NAV.
Worked in full in The Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The case comes from The Credit Investor: an investor puts $25,000 into each of three listed business development companies. All three are fictional and every rate is the book's assumption, not market data. SOFR is taken at 4.00 per cent, assets earn SOFR plus a spread, and the debt cost is held fixed.
| Input | Ledgerwood | Tamsin | Corlett |
|---|---|---|---|
| Share price | 19.00 | 15.00 | 9.00 |
| NAV per share | 20.00 | 14.00 | 11.25 |
| Quarterly dividend | 0.48 | 0.40 | 0.33 |
| Asset spread over SOFR | 6.90% | 6.00% | 8.30% |
| Leverage, debt to equity | 1.10x | 1.00x | 1.35x |
| Cost of debt | 6.00% | 5.80% | 6.80% |
| Base fee, on gross assets | 1.50% | 0.00% | 1.75% |
| Other expenses, of NAV | 0.90% | 2.00% | 1.10% |
| Incentive fee, of pre-incentive NII | 17.5% | 0.0% | 20.0% |
| Loans on non-accrual | 1.0% | 0.8% | 4.0% |
Work per unit of NAV, because that is what the shareholder owns, then convert to a per-share quarterly figure. For Corlett, gross assets are 1 plus leverage, or 2.35 times NAV. Each line of the stack is a percentage of NAV a year:
Interest income = 2.35 × 12.30% × (1 − 4.0%) = 27.75%
less interest on debt = 1.35 × 6.80% = 9.18%
less base fee = 2.35 × 1.75% = 4.11%
less other expenses = 1.10%
= pre-incentive NII 13.36%, less incentive 20% = 2.67%, gives NII of 10.69% of NAV
NII per share, a quarter = 11.25 × 10.69% / 4 = 0.3005
Coverage = 0.3005 / 0.33 = 91.1%, or 0.91x
Excel: =NAV*((1+Lev)*(SOFR+Spread)*(1-NonAcc)-Lev*Kd-(1+Lev)*BaseFee-Other)*(1-Incentive)/4/Dividend
The incentive fee is modelled as a flat share of pre-incentive NII, without a hurdle, as the book's workbook does. Many real fee agreements include a hurdle and a catch-up; read the prospectus and model the one that applies.
The same arithmetic for all three shows why the displayed yield is a poor guide:
| BDC | Dividend yield on price | NII yield on price | NII per share | Dividend | Coverage |
|---|---|---|---|---|---|
| Ledgerwood | 10.11% | 10.43% | 0.4955 | 0.48 | 103.2% |
| Tamsin | 10.67% | 11.24% | 0.4214 | 0.40 | 105.4% |
| Corlett | 14.67% | 13.36% | 0.3005 | 0.33 | 91.1% |
The highest yield is the only one the income does not pay. Corlett is short by 0.0295 a share every quarter, 0.12 a year, which is 1.05 per cent of NAV paid out of capital before a single credit loss is recognised.
Every point of asset yield or non-accrual hits a leveraged BDC 2.35 times, because it is earned on gross assets and reported on equity. After the 20 per cent incentive fee takes its share, the net multiplier on NII is still 1.88. One extra point of non-accruals costs Corlett 0.0065 of quarterly NII per share, or about 2.0 points of coverage.
| Non-accruals | NII, of NAV | NII per share | Coverage |
|---|---|---|---|
| 0% | 11.61% | 0.327 | 98.9% |
| 2% | 11.15% | 0.314 | 95.0% |
| 4% | 10.69% | 0.301 | 91.1% |
| 7% | 9.99% | 0.281 | 85.2% |
| 9% | 9.53% | 0.268 | 81.2% |
Even with every loan paying, coverage is 98.9 per cent. The dividend was set for a better rate environment than the one the model assumes, and no improvement in credit quality closes the gap.
Floating-rate assets funded with debt whose cost does not move, as modelled here, make NII a bet on the reference rate. Where part of the debt floats too, the sensitivity is smaller. Each 100 basis points of SOFR moves Corlett's quarterly NII by 0.051 a share, or 15.4 points of coverage.
| SOFR | NII, of NAV | NII per share | Coverage |
|---|---|---|---|
| 3.00% | 8.88% | 0.250 | 75.7% |
| 3.50% | 9.78% | 0.275 | 83.4% |
| 4.00% | 10.69% | 0.301 | 91.1% |
| 4.50% | 11.59% | 0.326 | 98.8% |
| 5.00% | 12.49% | 0.351 | 106.4% |
The dividend is covered only above a SOFR of 4.58 per cent at today's non-accruals, or 4.07 per cent if every loan paid. In the book's base case Corlett cuts its dividend to 0.25 in quarter 6, a cut of 24.2 per cent. At quarter-1 income that cut would restore coverage to 120.2 per cent, which is what a board resetting a dividend usually aims for: room, not parity.
The usual error is to judge coverage from the wrong numerator. Total investment income ignores interest and fees. Net increase in net assets from operations includes unrealised gains and losses, so a quarter of marked-up loans can make an uncovered dividend look safe. Coverage on price confuses the market's discount with the company's income. The test is NII, or the company's adjusted NII if it strips out an accrued capital gains incentive fee, divided by the dividend declared for the same quarter.
The second error is to read one quarter. Spillover income from earlier years can fund a gap for a while; it does not make the gap disappear. Track the trend of coverage and the trend of NAV together. A BDC paying 91 per cent covered dividends will usually show a NAV that drifts down by roughly the shortfall plus its credit losses.
The full income stacks, the quarter-by-quarter NAV paths and the dividend cut are live formulas in the free workbook for this case. Whether Corlett's 20 per cent discount to NAV compensates for the shortfall is worked in is a BDC trading below NAV cheap?, and the same logic applied to a single bond is in a high-yield bond's yield after expected default losses.
Coverage at or above 100 per cent means net investment income pays the whole dividend; many investors look for a margin above that, because one weak quarter of non-accruals can remove several points. In the worked case Ledgerwood covers 103.2 per cent and Tamsin 105.4 per cent, while Corlett, with the highest displayed yield at 14.67 per cent, covers 91.1 per cent and pays the rest from NAV.
Income and the base fee are earned on gross assets while coverage is measured on equity. At 1.35x debt to equity, gross assets are 2.35 times NAV, so each point of asset yield lost moves NII by 2.35 points before the incentive fee and 1.88 after it. One extra point of non-accruals costs Corlett about 2.0 points of coverage.
Yes, when assets float and the debt cost does not. In the case, with the debt cost held fixed, each 100 basis points of SOFR moves Corlett's NII by 0.051 a share a quarter, about 15.4 points of coverage. At a 3.00 per cent SOFR coverage falls to 75.7 per cent; the dividend is covered only above a SOFR of 4.58 per cent.
This article is one calculation from The Credit Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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