Fitch: BDCs Positioned to Cope with Rising Rates over Time
CHICAGO -- August 15, 2013
Increased exposure to floating-rate investments and generally heavy use of
fixed rate funding has positioned U.S. business development companies (BDCs)
well to adjust to the rising rate environment longer term, according to Fitch
Ratings. However, near-term earnings may be squeezed by slight upticks in
interest rates, as many BDCs deal with interest rate floors on their
floating-rate debt investments.
For some time now, BDCs, publicly traded lenders to middle-market companies,
have moved to increase the share of floating-rate debt in their investment
portfolios. Floating-rate instruments represented between approximately 35%
and 80% of total investments for Fitch-rated BDCs as of June 30.
For BDCs with heavy exposure to floating-rate investments, rising rates boost
interest income, profitability and dividend coverage. However, rates will
generally need to rise at least 100 bp for BDCs to reap the benefits of the
additional income, given the impact of interest rate floors. At the same time,
heavy reliance on floating-rate debt can erode profitability gains as interest
costs rise. The fixed floating funding mix for BDCs can fluctuate throughout
the quarter as floating-rate revolvers are utilized for funding, prior to
being paid down by fixed rate unsecured debt issuance.
Fixed rate funding for many BDCs has increased significantly over the past
year given the attractiveness of the unsecured debt markets. As such, many
BDCs have become less reliant on their secured floating-rate revolvers. At
June 30, the average Fitch-rated BDC funding profile, excluding American
Capital (ACAS), which is 100% floating-rate debt funded, was comprised of
approximately 69% fixed rate debt.
An additional risk linked to rising rates is that portfolio companies may come
under greater financial stress as interest payments on floating-rate debt
increase. In general, however, Fitch believes that BDC underwriting teams have
likely factored in these risks when originating deals. Portfolio companies'
cash flows could also improve if rising rates signal some fundamental
improvement in the economy.
Besides a focus on increased exposure to floating-rate investments, some BDCs
have also chosen to hedge against the risk of rising funding costs through the
use of interest rate caps for their revolvers and term loans.
Among the largest BDCs, Fitch believes Ares Capital Corp. (Ares) is well
positioned to benefit from higher interest rates due to its heavier reliance
on floating-rate investments (79% as of June 30) and use of fixed rate
unsecured notes and convertibles (75% at June 30) for funding. At June 30,
Ares reported that a 200 bp rise in interest rates would increase its annual
interest income by $29.4 million, all else equal.
The above article originally appeared as a post on the Fitch Wire credit
market commentary page. The original article can be accessed at
www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
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