Be skeptical about the claim that variable rate loans will raise Business Development Company (or BDC) Net Investment Income (or NII) as interest rates rise in 2014. It is my belief that recent articles here on Seeking Alpha have misled you on that important issue. Since the argument sounds so logical on the surface, my level of proof needs to be substantial. I believe it is.
The six factors that make me skeptical
(1) Long-term rates went up in 2013. The ten year ended 2012 at 1.76%. That rate closed Friday at 2.87%. But what has happened to the "weighted average yield" numbers for BDCs? In most cases, that rate went down. On a non-cap weighted sector average basis, weighted average yields have fallen from 12.01% at the start of the year to 11.49% at the end of Q3-13.
Five BDCs have had substantial falls in weighted average yields in the last three quarters: Ares Capital Corporation has a fall to 9.50% from 11.40%, Golub Capital BDC has a fall to 9.60% from 11.20%, Prospect Capital Corporation has a fall to 13.60% from 14.70%, Solar Capital has a fall to 11.60% from 14.20% and THL Credit has a fall to 12.10% from 13.90%. That entire group had secondary offerings in 2013 that should have increased the relative percentages of new loans into their portfolio. Below is a spreadsheet containing that data for the full sector.
Portfolio Assets, Share Count Change and Yield Sensitivity
Most - but not all - BDCs have had falling weighted average yields on their portfolio company investments in 2013. The fall was not consistent across the sector. Why? The following spreadsheet is my attempt to answer that question. Here are my general findings on this inconsistent event: The larger the portfolio growth, the greater the fall in yields.
I did not gather the data to capture changes towards improved portfolio safety. I attempt to gather stats on portfolio turnover - but BDCs are inconsistent with those stats. Some fail to report it. Few report turnover by quarter - but for multiple quarter periods. Due to differences in the start of the fiscal years, turnover for multiple quarter periods fail to overlap. I also did not gather the changes in the percentage of the portfolios that were in non-income producing assets. Those problems in data gathering result in problems when it comes to finding a cause of the falling yields.
In the spreadsheet below, the share counts are in millions of shares. The leverage calculation divides debt per share by NAV per share. The portfolio weighted average yield stats are from company earnings releases.
|Loans by Type||Port Weighted Av Yield||2013 Change||End of Quarter Share Count||EPS Change||Leverage|
(2) Is there a simple explanation for this disconnect between rising interest rates and falling BDC weighted average yields? The data from bankrate.com tells us that the current 90 day LIBOR rate is 0.24%. It was 0.24% last month. It was 0.31% this time last year. It is the long-term (or 10 year US treasury) rates that are rising and capturing the headlines. Short-term rates - the ones that trigger increases in floating rate loans - are mostly flat.
(3) Given the way the terms in the BDC portfolio loans are structured, I believe that variable rate loans are "de facto" fixed rate loans due to their high floors. The floors begin around 75 basis points (or bps) for better quality senior secured loans - and go up from that to as high as 600 bps and in some cases beyond. The loans that produce BDC incomes have high floors that will only adjust due to major changes in short-term rates. Short-term rates are not moving.
Let's briefly review what's going on with the Fed using wording copied from their web site.
"In late 2008 the Federal Reserve began a series of large-scale asset purchases. In conducting large-scale asset purchases, the Fed purchases longer-term securities issued by the U.S. government and longer-term securities issued or guaranteed by government-sponsored agencies such as Fannie Mae or Freddie Mac. The Fed's purchases reduce the available supply of securities in the market, leading to an increase in the prices of those securities and a reduction in their yields. Lower yields on mortgage-backed securities mean lower mortgage rates as well. Moreover, private investors respond to lower yields on U.S. Treasury securities and agency-guaranteed mortgage-backed securities by seeking to acquire assets with higher yields - assets such as corporate bonds and other privately issued securities. Investors' purchases should raise the prices of those securities and reduce their yields."
The Fed was currently making $85 billion-a-month in Treasuries and mortgage-related assets. The Fed is now beginning to reduce or taper those purchases. With the size of the asset purchases beginning at such a high level, it appears logical that there is a lot of tapering to do. And once the tapering is finished, there are a lot of asset sales ahead. That leads me to what I believe is a logical conclusion. It could be multiple years before the Fed starts to adjust short-term rates where it has a strong influence.
(4) At the same time that we have investors writing and thinking that rising rates will aid BDC income, the few BDCs that publish interest rate sensitivity stats in their 10-Qs and 10-Ks are implying the opposite.
From Golub Capital BDC's last 10-K: Assuming that the consolidated statement of financial condition as of September 30, 2013 were to remain constant and that Golub took no actions to alter our existing interest rate sensitivity, the following table shows the annualized impact of hypothetical base rate changes in interest rates. The data is in thousands.
|Change in interest rates||Increase (decrease) in interest income||Increase (decrease) in interest expense||Net increase (decrease) in investment income|
|Down 25 basis points||$ (26)||$ (582)||$ 556|
|Up 100 basis points||230||2,326||(2,096)|
|Up 200 basis points||9,101||4,740||4,361|
|Up 300 basis points||18,580||7,154||11,426|
From Fifth Street's last 10-K: A 100 bps increase in interest rates would increase interest income by $1.3 million while increasing interest expense by $1.9 million - while a 200 bps increase would increase interest income by $9.8 million while increasing interest expense by $3.8 million.
From Apollo's last 10-Q: A 100 bps (basis points) increase in interest rates would decrease their net investment income by $0.747 million or $0.003/share while a 200 bps increase in rates would increase income by $11.450 million or $0.051/share.
Approximately 37% of Apollo's investment portfolio is in floating rate loans, compared to 67% for Fifth Street Finance and 85% for Golub Capital. Despite those big differences, the effect of rising short-term rates are surprisingly similar for the three. All three require more than a 100 bps increase in short-term rates before the effect turns positive.
While a minor focus on the article has been on the BDCs with significant falls in weighted average yields, most of those BDCs (Prospect, Solar and THL Credit) lack disclosure of their interest rate sensitivity. If disclosure is going to improve, it is up to people reading articles like this to start requesting that data.
(5) BDCs with floating rate loans lend at "x plus LIBOR" - and it is the focus of most of the financial writers and post article comments that the big change that will come from the tapering will be the boost in LIBOR. The data from 2013 says that the consensus is wrong. The big change in Net Investment Income will come from the change in x in new loans that is in the "x plus LIBOR" formula.
(6) It is my theory that quantitative easing had the effect of lowering the x in "x plus LIBOR" loans in 2013. If that is the case, then a tapering of that quantitative easing should have the effect of raising the x in the "x plus LIBOR" loans in 2014. On the surface, that is good news. But it appears to me that too much of this good news is already in the existing 2014 analyst EPS projections.
I hope I made a clear and strong case that the consensus is wrong on their expectations that rising long-term rates will also raise BDC Net Investment Income due to increased income from floating rate loans.