OREANDA-NEWS. The Sector and Rating Outlooks for U.S. business development companies (BDCs) remain Negative for 2016, according to Fitch Ratings' 2016 BDC Outlook report published today. BDCs continue to face a number of challenges heading into a new year, including competitive underwriting conditions, underperforming energy investments, unsustainable asset quality metrics, and limited access to growth capital, which are likely to pressure the ratings of certain BDCs over the next year, according to Fitch.

BDCs have had limited access to growth capital in 2015 as share prices continued to trade at steep discounts to net asset value (NAV). While a reduction in the rate of portfolio growth is viewed favorably by Fitch, given tough underwriting conditions, some firms may struggle to close the trading gap, leaving them at a competitive disadvantage when investment opportunities arise. At Oct. 30, 2015, the rated peer group was trading at a 19.5% discount to NAV.

Given the share price discount, Fitch believes share repurchase activity is likely to increase in coming quarters. If the earning accretion achievable through a buyback is greater than any accretion otherwise achievable through investments in new loan assets, then creditors could benefit from stronger cash flow coverage of the dividend. That said, if share repurchases inflate leverage beyond levels commensurate with portfolio risk; that would be viewed negatively by Fitch.

Industrywide asset quality metrics, most notably non-accrual levels, remain at unsustainably low levels, in Fitch's opinion. While strong portfolio company performance has been supported by an improving economic environment, low interest rates are likely masking some potential underlying company-specific issues, as issuers have been able to refinance themselves out of trouble and loosen covenant packages rather easily in recent years. Fitch believes asset quality metrics are likely to deteriorate over the near term; however, the pace of deterioration will be somewhat dependent upon the rate of change in interest rates, the backdrop of the broader economic environment, differing sector exposures, and the quality of individual firms' underwriting.

The precipitous decline in commodity prices over the past 18 months has yielded the first notable crack in asset quality performance for those BDCs with outsized energy exposure, as Fitch has observed numerous write-downs since third quarter 2014 (3Q14). Liquid positions have sustained the most significant marks, given the direct transmission of negative market perception, but illiquid investments could experience increased valuation hits heading into 2016, absent a rebound in oil prices, particularly as portfolio company hedges begin to mature and roll-off. Fitch's stress testing indicates that exposures are generally manageable, but certain BDCs' leverage ratios could be pressured.

On a positive note, ratings remain supported by a strong regulatory framework that limits the amount of leverage that can be assumed, which is a key rating consideration. Average leverage for investment grade-rated BDCs was 0.61 times (x) at June 30, 2015 compared to 0.59x at year-end 2012. However, there is a wide dispersion of leverage tolerance underlying this metric, and those with the most energy exposure have the highest leverage ratios. Fitch believes that BDCs heavily focused on maximizing leverage risk having less dry powder to deploy when underwriting conditions improve, thus, weakening earnings upside.

Rating activity on issuers in Fitch's BDC portfolio was negative in 2015, and Fitch believes there is potential for some further negative rating actions at the issuer level in 2016 as reflected by the four BDC ratings that are on Negative Rating Outlook.

The full report '2016 Outlook: Business Development Companies' is available at 'www.ftchratings.com'.