BDCs as a fallen angels opportunity | Insight Investment

Business development companies (BDCs) have had a tough year so far, putting several “on watch” for potential downgrades from investment grade to high yield. Due to market dynamics, this could present opportunities.

Downgrade waves have historically had an upside

Sector concerns occasionally drive waves of credit ratings downgrades, which can broaden the universe of “fallen angels” (investment grade bonds downgraded to high yield).

For example, the 2008 financial crisis preceded banking sector downgrades, the 2015-2016 credit crisis led to many energy sector downgrades and several consumer cyclicals suffered downgrades during the pandemic (Figure 1).

Figure 1: Waves of sector downgrades have historically been good news for fallen angel investors¹

Although downgrades are often considered painful, opportunistic investors (particularly dedicated fallen angel strategies) can potentially benefit. In our experience downgrades result in simultaneous forced selling from passive and less flexible active investment grade accounts, allowing other investors to pick the bonds up at potentially oversold levels.

Will BDCs be the next downgrade wave?

Business development companies are US investment vehicles that typically lend to small and medium-sized private companies and distribute most of their interest income to equity investors. They are a product of the US investment company regulatory framework and do not have a direct European equivalent, although they can be broadly compared to listed private credit vehicles or closed-ended investment trusts. In recent years, BDCs have also increasingly issued bonds (Figure 2 – below).

However, it has been a difficult year for the sector. ~20% of private BDC loans are to software companies² (a sector which has been the worst-performer sector in the S&P 500 index year-to-date at -15.6%³).

In equity markets, BDCs have delivered a -7.7% total return year-to-date, versus the S&P 500 Index at 5%⁴. In corporate bonds, BDCs (which are predominantly BBB-rated) have gone from trading between their BBB and BB peers, to in step with BBs (Figure 2 below).

Figure 2: Largely BBB-rated BDCs are now trading in step with their BB-rated peers⁵

In March, FS KKR Capital became the first fallen angel BDC of 2026 (following Prospect Capital in 2024 and BlackRock TCP Capital in 2025)⁶. The downgrade impacted $3.35bn of debt (via six bonds) with $2.2bn entering the Bloomberg US High Yield Fallen Angels 3% Constrained Index (due to the index’s constraints around issuer concentrations).

In April, Fitch retained its “deteriorating” credit outlook for the BDC sector, additionally noting pressure on earnings, dividend coverage, and funding flexibility⁷.

Nonetheless, we expect any increase in BDC downgrades will be selective, rather than immediate and broad‑based. Currently no investment grade BDCs carry a high yield rating from any agency (a transition of a bond from investment grade to a high yield indices requires at least two high yield ratings) and only one BDC issuer is on negative outlook (Figure 3).

Figure 3: BDC fallen angels may be more of a stagger than a wave⁸

Additional downgrades in the near term could drive forced selling across a wider range of BDC bonds, including those with stronger balance sheets (a dynamic we have seen before).

Defaults may potentially be less of a risk than downgrades in BDCs

Perpetual BDCs have no wind-up date and, due to their unlisted nature, are at direct risk of withdrawals. However, they typically limit withdrawals to 5% of NAV per quarter. Barclays data indicates that even in an adverse scenario, BDCs have robust enough liquidity (via cash and undrawn credit facilities) to service withdrawals at this rate through multiple quarters⁹.

Elsewhere, Fitch noted that under a severe stress test of 50% write-offs on software exposures (with no offsetting actions), the vast majority of rated BDCs would still likely meet asset-coverage requirements¹⁰.

Non‑accrual rates (the proportion of troubled loans that BDCs no longer book interest on) appear relatively contained for now¹¹. Outside of non-accruals, BDCs generally have modest private loan exposure to riskier payment-in-kind (PIK) deals with a price currently marked below 90% of par value¹². Several higher-rated BDCs also emphasize exposure to senior secured deals¹¹.

Conclusion: We believe BDCs may be an area to watch for fallen angel opportunities

The most recent BDC downgrades saw the issuers’ bond spreads widen materially as they transitioned from investment grade to high yield indices, potentially representing outsized compensation for credit risk.

Nonetheless, we see significant performance dispersion in terms of fundamental metrics. As always, through downgrade cycles, selectivity and structural awareness will be critical. A diversified systematic approach targeting bottom-up alpha, or flexible active strategies, may be best-placed to potentially take advantage.