This is Part 6 of a series of articles that will compare the risk profiles for the 25 business development companies ("BDCs") recently covered in my "The Good, The Bad, And The Maybe" series. This article focuses on the interest rate sensitivity for BDCs considering fixed versus variable rate investments compared to the amounts borrowed to fund the investments.
Previous Risk Profile Articles:
- Part 1 - Portfolio Asset Classes and Non-Accrual Rates
- Part 2 - Volatility Ratios
- Part 3 - Leverage
- Part 4 - Insider and Institutional Ownership
- Part 5 - Industry Diversification
When evaluating BDCs, I focus on five general criteria: profitability, risk, payout, analyst opinions, and valuation. When assessing risk relative to other BCDs, I take into account many factors including: portfolio credit quality, investment asset classes, diversification, non-accrual rates, portfolio yield, fixed/variable rate loans, leverage, interest rate sensitivity, volatility ratios, market capitalization, insider ownership and trends, institutional ownership and trends, and management/operational history. I will cover each of these areas as well as the other factors I use to rank the risk profiles for each BDC. Below are the current risk rankings for each BDC, and for the most recent overall rankings, see "Latest BDC Rankings For Q1 2013".
Fixed Versus Variable Loans
Most BDCs have a majority of debt investments bearing floating rate loans with LIBOR or prime rate based floors. Some have a stated intention of 80% or more of investments will bear variable rates such as PennantPark Floating Rate Capital (PFLT) and Gladstone Investment (GAIN). However there are a few BDCs with mostly fixed rate loans such as Triangle Capital (TCAP) at 98% of debt investments, and Fidus Investment (FDUS) stating 'debt investments generally bear interest at fixed rates' and Horizon Technology Finance (HRZN) stating:
the interest rates on the loans within our portfolio were mostly at fixed rates and we expect that our loans in the future will also have primarily fixed interest rates.
Interest Rate Sensitivity
Interest rate sensitivity refers to the change in net earnings that may result from changes in the level of interest rates. Because most BDCs fund a portion of investments with borrowings, earnings are affected by the difference between the interest rate at which they invest and the interest rate at which they borrow. Below is a chart showing the amount of floating rate loans for each BDC along with the leverage ratios discussed in Part 3 - Leverage.
This chart does not account for the portion of borrowings that are fixed versus variable or maturity dates, which are both critical in determining rate sensitivity. As of March 31, 2013, American Capital (ACAS) had approximately 44% of debt investments at fixed rates, approximately 25% were at variable rates with interest rate floors, primarily one-month LIBOR, 9% were at variable rates with no interest rate floors and 22% were on non-accrual status. Approximately 10% of borrowings bear interest at variable rates with no interest rate floors, and 90% bear interest at variable rates with a 1.25% interest rate floor.
ACAS has very low sensitivity from an income and expense standpoint due to less variable rate investments and lower debt, but is not positioned well for a potential rise in interest rates, as shown in the table below, with the annual impact on NOI and net earnings of base rate changes in the applicable interest rate indexes, (considering interest rate floors for variable rate instruments and excluding changes in the fair value of investments and derivative instruments and loans on non-accrual status) assuming no changes in investment, hedging and borrowing structure:
Ares Capital (ARCC) is positioned very well if rates increase over 200 basis points, as shown in the table below with the annual impact on net income of base rate changes in interest rates. As of March 31, 2013, ARCC had approximately 14% of investments bear interest at fixed rates, approximately 75% bore interest at variable rates, 10% were non-interest earning and 1% were on non-accrual status. Additionally, for the variable rate investments, 70% of these investments contained interest rate floors (representing 53% of total investments at fair value). The Facilities all bear interest at variable rates with no interest rate floors, while the Unsecured Notes and the Convertible Unsecured Notes bear interest at fixed rates.
Fifth Street Finance (FSC) is also positioned favorably for interest rates to rise given the 74% of debt investments bearing floating rates. The following table shows the approximate annualized increase (decrease) in components of net assets resulting from operations:
TCP Capital (TCPC) is positioned well for rates to fall or increase over 200 basis points as shown in the following table with the annual impact on net income:
The same analysis for FDUS and HRZN is not readily available and, as discussed earlier, both have a majority of investments with fixed rates and are not positioned well for a rise in rates. FDUS has stated:
a hypothetical 100 basis point change in interest rates would not have a material effect on our level of interest income from debt investments or interest expense.
Conversely, HRZN states:
a hypothetical immediate 1% change in interest rates may affect net income by more than 1% over a one-year horizon
This gives me increased concern in that environment.
Interest rate sensitivity, fixed/variable rate investments, industry diversification, market capitalization, insider and institutional ownership, leverage, volatility ratios, portfolio investment grades, and non-accruals are just some of the many considerations when evaluating risk for BDCs, and I will try to cover the rest in the remainder of this series.
For more information about BDCs and how I evaluate them, please see this article.