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As interest rates start to rise, how will Business Development Companies ("BDC") such as Ares Capital (NASDAQ:ARCC) perform? Recently we have seen some rates rising, resulting in turbulence for rate sensitive stocks such as BDCs. Yesterday, the slide continued except for one BDC, ARCC, and this could have been a coincidence or maybe investors see the potential that I do. Since 2008, ARCC has moved toward safer investments with 75% at variable rates while reducing its debt-to-equity ratio to 0.55 with 88% of borrowings at fixed rates, positioning it well for a potential increase in rates.

Why do I think ARCC will do well in a rising rate economy?

  • Moving toward safer investments
  • Most investments have floating rates
  • Lower-than-average debt to equity
  • Most borrowings have fixed rates

In my previous article "BDC Risk Profiles: Part 6 - Interest Rate Sensitivity" I discussed how ARCC was positioned well, but given the recent circumstances I will expand my analysis.

Safer Investments:

ARCC has been consistently decreasing its weighted average yields for each asset class well as increasing the amount of senior debt as a portion of the overall portfolio as shown in the chart below. The average yield on income producing investments was 11.0% as of March 31, 2013, down from 12.8% in 2008. On the most recent earnings call, the CEO stated, "We remain focused up the balance sheet on floating rate, shorter duration senior debt investments, and defensively positioned companies. We have to have a willingness to accept lower asset yields for higher-quality investments in this environment, knowing that we can improve returns through syndication and structuring."

(click to enlarge)

The chart below shows the portfolio leverage multiples increasing from 4.3x to 4.6x which is still below many other BDCs and the interest coverage ratio increasing to 2.7x as a sign that its portfolio companies have sufficient income for debt service and are improving.

(click to enlarge)

Overall, I consider ARCC one of the safer BDCs as discussed in my "BDC Risk Profile" articles.

Floating Rate Investments:

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 average BDC has about 60% of debt investments with floating rates giving ARCC an advantage over other BDCs as shown in the chart below:

(click to enlarge)

Debt to Equity:

Most BDCs are Regulated Investment Companies and "are only allowed to borrow amounts or issue debt securities or preferred stock, such that asset coverage, as calculated in accordance with the Investment Company Act, equals at least 200%". This equates to debt-to-equity ratio of 1.00 but there are certain exceptions that allow them to borrow more including SBA loans, which are exempt from the coverage ratio. Since 2008, ARCC has reduced its debt-to-equity ratio from 0.83 to 0.55 as well as increasing the amount of fixed rate borrowing to 88% of the total as shown in the chart below:

(click to enlarge)

Fixed Rate Debt:

Most (88%) of ARCC's debt is at fixed rates that currently average 5.5% with a weighted average maturity of 10.4 years. This puts the company at an advantage compared to most BDCs with large amounts of variable debt and/or shorter maturities. There are no debt maturities until 2016.

(click to enlarge)

The Impact of Rising Rates:

ARCC regularly measures its exposure to interest rate risk and manages exposure on an ongoing basis by comparing interest rate sensitive assets to interest rate sensitive liabilities, and employs hedging transactions to mitigate exposure to changes in rates. The following table shows the annual impact on net income of base rate changes in interest rates (considering interest rate floors for variable rate instruments) assuming no changes in its investment and borrowing structure for the last four years and the most previous quarter:

(click to enlarge)

Since 2009, ARCC has grown its portfolio with variable rate loans that will hopefully perform well and provide additional income if rates were to rise. Additionally, as ARCC has decreased its debt-to-equity ratio and raised much of its capital through debt offerings with fixed rates, it has significantly reduced its exposure from an expense standpoint. The worst-case scenario would be an increase of only 100 basis points that would have a negative impact of $15.2 million on annualized net income or approximately $0.06 per share. However, if rates were to increase 300 basis points there would be a positive impact to net income of $63.6 million or $0.24 per share.

On the most recent earnings call, the CEO stated, "There will come a time when interest rates do rise and spreads will widen out again, and when they do, we want to have a large, diversified portfolio with as little asset level risk as possible and significant liquidity to take advantage of any market disruption. To that end, we believe we're currently very well positioned, with a strong balance sheet, a sizable amount of available debt capacity and a well-performing portfolio."

ARCC is adequately covering its quarterly dividend of $0.38 giving it a sustainable yield of over 9%, and could potentially benefit from an increase in rates. Interest rate sensitive stocks are experiencing selling pressure in the fear of rising rates, but I think ARCC will ultimately rise to the top as investors see the upside potential.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.