This article is a follow-up to Part 2 of my recent series of articles discussing which BDCs are better positioned for rising interest rates. Please read "Rising Interest Rates & BDCs: Part 1" discussing the core drivers that impact a BDC's net investment income, including:
- Amount of variable rate investments
- Various levels of implied floors for investments (most important)
- Fixed vs. variable rate borrowings
- Income incentive fees
- Growth capital (variable debt vs. other)
Prospect Capital (NASDAQ:PSEC) provides limited information regarding the potential impact to net investment income ("NII") if interest rates rise by only 1% that is usually the point when very few investments provide additional income, but interest expense on credit facilities would be fully impacted. The following statement is the entire "Quantitative and Qualitative Disclosures about Market Risk" section of the latest 10-Q:
"We are subject to financial market risks, including changes in interest rates and equity price risk. Some of the loans in our portfolio have floating interest rates. We may hedge against interest rate fluctuations by using standard hedging instruments such as futures, options and forward contracts subject to the requirements of the 1940 Act. While hedging activities may insulate us against adverse changes in interest rates, they may also limit our ability to participate in the benefits of higher interest rates with respect to our portfolio of investments. During the three months ended March 31, 2014, we did not engage in hedging activities."
The investor presentation has a bit more information regarding how changes in interest rates would impact the company including the following:
The "Portfolio Investments" section of PSEC's latest 10-Q states: "As of March 31, 2014, $4,517,031 of our loans, at fair value, bear interest at floating rates and $4,483,477 of those loans have Libor floors ranging from 1.25% to 6.00%." This implies that 99.3% of its variable rate loans have LIBOR floors over 125 basis points.
Variable Rate Borrowings
As of March 31, 2014, PSEC had $729 million outstanding on its credit facility at a variable rate of 1-month LIBOR + 275 basis points and commitment fees based on the amount of the unused portion of the revolver. PSEC continually uses this facility for working capital to fund purchases and then pays it off by issuing fixed rate debt or new shares.
Since March 31, PSEC has:
- Issued 7.7 million shares raising $84 million
- Issued $300 million of senior unsecured notes at 5.00%
- Issued $400 million of senior convertible notes at 4.75%
- Increased total commitments to its credit facility by $85.0 million to $877.5 million
I have assumed that PSEC will continue to use its credit facility to fund portfolio purchases in the short term but then use the issuances of additional equity and unsecured term debt to periodically pay down its revolver with an average outstanding balance of around $700 million or ~20% of borrowings going forward. This is much better than most BDCs and the 27% variable rate borrowings as of March 31, 2014. The credit facility includes an accordion feature that allows commitments to be increased up to $1 billion.
PSEC has structured product investments in the form of in collateralized loan obligations ("CLOs"). Many CLO investments have higher than average floors and use off balance sheet leverage to increase returns, which is why CLO investments have higher yields than other investments and are considered "unqualified" investments. BDCs are allowed a maximum of 30% of the portfolio in these types of investments due to the amount of risk involved. PSEC owns the "residual interest" in most of its CLO investments that are the last in line to be paid, and the first to be cut off if the underlying investments default.
The following disclosures are provided by PSEC regarding its CLO investments:
"We expect that a majority of our portfolio will consist of equity and junior debt investments in CLOs, which involve a number of significant risks. CLOs are typically highly levered up to approximately 10 times, and therefore the junior debt and equity tranches that we will invest in are subject to a higher risk of total loss. In particular, investors in CLOs indirectly bear risks of the underlying debt investments held by such CLOs."
"Payments to us as a holder of CLO junior securities are and will be made only after payments due on the senior secured notes, and, where appropriate, the junior secured notes, have been made in full. This means that relatively small numbers of defaults of Senior Secured Loans may adversely impact our returns."
"Generally, we are in a subordinated position with respect to realized losses on the Senior Secured Loans underlying our investments in CLOs. The leveraged nature of CLOs, in particular, magnifies the adverse impact of Senior Secured Loan defaults. CLO investments represent a leveraged investment with respect to the underlying Senior Secured Loans. Therefore, changes in the market value of the CLO investments could be greater than the change in the market value of the underlying Senior Secured Loans, which are subject to credit, liquidity and interest rate risk."
"Investments in structured vehicles, including equity and junior debt instruments issued by CLOs, involve risks, including credit risk and market risk. Changes in interest rates and credit quality may cause significant price fluctuations. Additionally, changes in the underlying Senior Secured Loans held by a CLO may cause payments on the instruments we hold to be reduced, either temporarily or permanently."
PSEC does not provide information on how rising interest rates would impact the payments from its CLO equity investments, but here is an example in the recent 10-Q from TICC Capital (NASDAQ:TICC):
"To illustrate the impact of a change in the underlying interest rate on our total investment income as it pertains to our CLO equity investments, we have assumed a 1% increase in the underlying three-month LIBOR, and no other change in our CLO portfolio, or to any of the credit, spread, default rate or other factors, as of June 30, 2014. Under this analysis, the effect on total investment income would be a decrease of approximately $20.0 million on an annualized basis, reflecting the portfolio assets held within these CLO vehicles which have implied floors that would be unaffected by a 1% change in the underlying interest rate, compared to the debt carried by those CLO vehicles which are at variable rates and which would be affected by a change in three-month LIBOR. If the increase in three-month LIBOR was more significant, such as 5%, the net effect on total investment income would be a decrease of approximately $13.1 million. Although management believes that this analysis is indicative of our existing interest rate sensitivity, it does not adjust for changes in any of the other assumptions that effect the return on CLO equity investments, both positively and negatively (and which could accompany changes to the three-month LIBOR rate), such as default rates, recovery rates, prepayment rates and reinvestment rates, that could affect the net increase (or decrease) in net assets resulting from operations. Accordingly, no assurances can be given that actual results would not differ materially from the results under this hypothetical analysis."
What the disclosure does not address is the potential impacts to net asset value ("NAV"). If rates go up the value of CLO equity investments may go down because of the reduced distributions to CLO equity holders.
The following table shows a side by side comparison of TICC and PSEC in an effort to quantify the impact to income from a 100 basis point rise in interest rates.
The truth is that we do not know the exact impact from rising rates on PSEC's investments, but given the potential for leverage up to 10 times I believe that a loss of income of $69 million if interest rates rise by 100 basis points is a likely scenario. However, for my best and worst case scenarios I have used decreased income of $50 million and $90 million, but this does not account for the potential for increased default rates. The following table shows these scenarios along with the additional income from its variable rate debt investments with floors below 125 basis points, increased interest expense from borrowings on the credit facility (at various levels) and changes to incentive fees paid to the external advisor.
I have also included the impacts from a 500 basis point increase that was provided by the company but have included the incentive fees associated with the increased income.
As you can see I am projecting a loss of between $0.13 to $0.23 per share on annualized earnings, but most likely this amount would be closer to $0.13 to $0.18 per share. Hopefully, PSEC would disclose any potential impacts of $0.20 per share or higher given the litigious nature of some of its shareholders. At this point, if rates were to rise by 1%, I would not consider PSEC to be the best positioned given the low amount of variable rate investments with floors below 125 basis points and the unknown impacts to NII and NAV from its CLO investments.
In the remaining articles in my interest rate related series, I will discuss the following:
- BDC borrowing rates
- Other expenses related to rising interest rates
Disclosure: The author is long PSEC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.