Fitch Ratings believes asset quality for business development companies (BDCs) could deteriorate further in 2016 following challenging energy performance in 2015, according to Fitch's latest North American Financial Institutions Chart of the Month. BDC portfolio non-accruals averaged 1.93% of debt portfolios, at value, at year-end 2015, up from 1.25% a year earlier.

'For several years BDC portfolio asset quality has been pristine, but the cracks that emerged in 2015 are likely to widen in 2016 due to higher underlying portfolio company leverage levels and rising second lien lending exposure,' said Meghan Neenan, Senior Director, Fitch Ratings.

BDCs have started to write-down exposure to oil and gas in their portfolios with low commodity prices pressuring valuations and performance. At year-end 2015, oil and gas exposure averaged 4.9% of rated BDC portfolios, down from 5.5% in third quarter 2015. Fitch's stress testing indicates that exposure is manageable and notes that a full write-off of oil and gas investments would only push one BDC above the 1.0x leverage limit, holding all else constant, as the majority of oil related exposure is in the senior part of the borrowers' capital structures.

At year-end 2015 average leverage for the investment grade peer group amounted to 0.74x, up 14 bps from the prior year. In Fitch's view, leverage has increased above targeted ranges due to share repurchase programs, declining valuations, upticks in non-accruals and reduced repayments. In addition, rated BDCs face a $1.5 billion debt wall in 2016, which Fitch expects will be refinanced with secured bank facility borrowings as capital markets access remains limited with most of the Fitch rated BDCs trading below net asset value (NAV). On March 15, 2016, rated BDCs were trading at a 17.4% average discount to NAV, reflecting shareholder concerns with portfolio valuations and dividend durability, among other factors.

'To mitigate rising leverage ratios, prudent BDC management teams will monitor cash levels carefully over the next few quarters as valuations are likely to remain under pressure,' added Neenan.

Despite the negative trends, ratings remain supported by a strong regulatory framework that limits the amount of leverage that can be assumed, which is a key rating consideration.

Fitch completed a peer review of ten publicly-rated business development companies (BDCs) on March 9, 2016, which concluded with two downgrades and five issuers having ratings on Negative Outlook or Negative Watch. Fitch's outlook on the sector and its ratings remains Negative, which could result in additional rating action over the course of 2016.