2 BDCs to Avoid as Rate Cuts Loom

The Federal Reserve's pivot toward rate cuts in 2025 has sent ripples through capital markets, with business development companies (BDCs) now facing a critical juncture. While lower rates typically ease borrowing costs and boost asset valuations, the structural risks embedded in overleveraged or poorly diversified BDCs could amplify losses when defaults rise and portfolios reprice. For income-focused investors, the key lies in identifying which BDCs are most vulnerable to this shift.

The Leverage Paradox

BDCs are designed to amplify returns through debt, but excessive leverage becomes a liability when economic conditions deteriorate. As of Q1 2025, NewtekOne (NEWT) and Horizon Technology Finance (HRZN) stand out as particularly exposed. Both have built their strategies on aggressive debt financing, yet their capital structures lack the cushions needed to weather a downturn.

1. NewtekOne (NEWT): A Debt-Driven Gamble

NewtekOne's debt-to-equity ratio of 5.95 as of June 2025 is staggering. This means the company's long-term debt ($1.81 billion) dwarfs its equity ($310 million) by nearly sixfold. While this leverage fueled rapid growth in digital banking and alternative lending, it also exposes the firm to margin compression and liquidity stress.

The risk crystallizes when rate cuts arrive. NewtekOne's portfolio relies heavily on fixed-rate loans, which will not benefit from falling rates. Meanwhile, its borrowing costs—already elevated due to its high leverage—could remain sticky if refinancing terms tighten. A 100-basis-point drop in interest rates might reduce its cost of funds marginally, but the company's net interest margin (3.04% in Q1 2025) is already thin. If defaults rise in its small-business borrowers, the fallout could be catastrophic.

2. Horizon Technology Finance (HRZN): Thin Asset Coverage

Horizon's leverage ratio of 129% (debt-to-equity) appears modest compared to NEWT, but its asset coverage ratio of 165% masks deeper vulnerabilities. While the company holds $126.3 million in liquidity, its portfolio of secured loans is concentrated in technology and healthcare—sectors prone to volatility.

The problem lies in Horizon's reliance on floating-rate debt. A rate cut would lower its borrowing costs, but only if it can pass these savings to borrowers. However, many of its loans are fixed-rate, meaning the firm's spreads could compress as rates fall. Worse, if a recession follows the rate cuts, defaults in its high-growth sectors could erode asset values faster than its 165% coverage ratio suggests.

Why These BDCs Will Underperform

Both NEWT and HRZN lack the diversification and liquidity buffers to withstand a repricing of risk. When rate cuts coincide with economic weakness, their portfolios will face dual pressures: falling asset values and rising defaults. For example, NEWT's 5.95 debt-to-equity ratio means a 10% decline in asset values could trigger a 59.5% drop in equity—a scenario that would force fire sales or dividend cuts.

In contrast, BDCs like PennantPark Floating Rate Capital (PFLT)—with a conservative 1.3 debt-to-equity ratio and a focus on floating-rate loans—stand to benefit from rate cuts. Their spreads widen as rates fall, and their diversified middle-market portfolios are less prone to sector-specific shocks.

Investment Advice

For investors seeking to hedge against the next market cycle, avoiding overleveraged BDCs like NEWT and HRZN is prudent. Instead, prioritize firms with:
1. Debt-to-equity ratios below 1.5x (e.g., PFLT).
2. Floating-rate loan portfolios to capitalize on rate cuts.
3. High asset coverage ratios (ideally above 200%) to cushion against defaults.

The Fed's rate cuts may offer a reprieve for some BDCs, but they will also expose structural weaknesses in the sector. By steering clear of the most leveraged players, investors can position themselves to thrive in a post-rate-cut world.