(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)
This is Part 3 of my evaluation of the significant changes for the 25 BDCs that I cover compared to the previous quarter. In Part 2 I discussed the dividend coverage from net investment income ("NII"), changes in net asset value ("NAV") per share and portfolio investment classes for each. In this article I will highlight the changes to the debt to equity ratios, the ability to cover interest payments on borrowing with quarterly NII, and the amount of floating rate investments. As interest rates rise these will be important factors for investors to consider.
The two BDCs that have not reported results are Prospect Capital (PSEC) and Full Circle Capital (FULL) but I have included them in the rankings using last quarter's results. These are the five general criteria I use to evaluate BDCs:
- Profitability (EPS to cover dividends, NAV and EPS growth)
- Risk (rate sensitivity, diversification, portfolio quality, volatility)
- Payout (sustainable, consistent, growing)
- Analyst Opinions
- Valuation (NAV, P/E, PEG)
The table below does not actually contain whole numbers and the totals might be different (by 1) due to rounding:
Debt to Equity and Interest Coverage
In my article "BDC Risk Profiles: Part 3 - Leverage" I discussed the use of debt for portfolio growth and the impacts to risk and earnings. The average debt to equity and interest coverage ratios did not change but there were many changes on an individual company basis. I believe this is a function of the BDC growth process since most BDCs are Regulated Investment Companies ("RICs") designed to avoid double taxation but are required to distribute at least 90% of interest, dividends, and gains earned on investments. As a result, BDCs must use debt or issue additional shares to fund growth and depending on where they are in the cycle of borrowing versus issuing shares these ratios will fluctuate. However there are some BDCs that are excellent at doing both and utilizing capital quickly to benefit shareholders.
THL Credit (TCRD) came out on top for this quarter and reduced its debt to equity while substantially increasing revenues and NII. Solar Senior Capital (SUNS) is another BDC with excellent interest coverage from NII and American Capital (ACAS) has the lowest debt to equity ratio because instead of paying dividends it buys back shares and reduces debt levels.
The BDCs that improved debt to equity ratios the most were TCRD, TCP Capital (TCPC), Fifth Street Finance (FSC) and PennantPark Investment (PNNT), while others such as SUNS, PennantPark Floating Rate Capital (PFLT), Main Street Capital (MAIN) and KCAP Financial (KCAP) increased debt levels the most compared to last quarter.
Interest coverage is calculated by taking NII and adding back interest expenses and then dividing the total by the interest expense. I use the most recent quarter and do not adjust for all one time income or expenses to normalize income and assume that the interest paid is close to a normalize run rate based on debts owed, making this a rough estimate. The BDCs that improved their interest coverage ratios the most were TCRD, TICC Capital (TICC), Gladstone Capital (GLAD) and New Mountain Finance (NMFC).
Below is a chart showing the most recent debt to equity ratios and interest coverage compared to the previous quarter. PSEC has not reported yet but I would expect to see similar debt levels that are close to the industry average but an interest coverage ratio higher than the previous quarter given the current EPS projections.
Floating Rate Investments
In my article "BDC Risk Profiles: Part 6 - Interest Rate Sensitivity" I focused on the interest rate sensitivity for BDCs considering fixed versus variable rate investments compared to the amounts borrowed to fund the investments. The average BDC has around 67% of debt investments bearing floating rates that could potentially provide for increased income in a rising rate environment. The chart below shows the amount floating rate loans for the most recent and previous quarters.
The BDCs with the largest increases in floating rate investments were TCPC, PNNT, KCAP, and Solar Capital (SLRC). The BDCs with the largest decrease in floating rate investments were ACAS, SUNS, TICC and BlackRock Kelso Capital (BKCC).
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. Quantifying how sensitive a BDC is to a potential rise in rates is difficult because it depends on the use of hedging instruments and the underlying agreements of borrowings and investments among many other things. However some BDCs provide general detail about the annual impact on net income of base rate changes in interest rates such as Ares Capital (ARCC) that provided the table below:
In general, the BDCs with higher amounts of variable rate investments and lower amounts of debt with higher interest coverage should perform better in a rising rate environment but it is not always the case and investors should take time to go through the financials before investing. Not all companies provide as much detail as ARCC and it is only a static view at a single point in time that could change based on many factors.
In the remainder of this series I will cover PSEC and FULL as well as some of the other criteria I use for my rankings including portfolio yields and non-accruals. I will also cover overall risk levels and profitability as well as revised analyst EPS expectations and target pricing for each BDC.
Investors should only use this information as a starting point for due diligence. See the following for more information:
- BDC Investment Philosophy for general BDC information
- List of 25 BDCs that I follow
- BDC Risk Profiles