Interest rates

Tired of rising interest rates? Take advantage of it via the BDCs!

A rising rate environment can be scary. After years of enduring market euphoria, the moment many investors had feared was coming (and many hadn’t even imagined it was possible in the first place) has already become the norm. Who would have thought that near-zero rates wouldn’t be sustainable forever, right?

However, over the past few months, we have all experienced the direct result of rising rates. When rates go up, stocks go down. Why is that? In the simplest possible format, think of it this way:

Government bonds are generally considered risk-free securities. If the risk-free rate (yield) in the market environment increases, investors demand a higher return from risky securities (e.g. stocks) than before (i.e. they value these declining titles). If I can get 4% out of a government bond, I may no longer demand, say, an 8% expected return from a stock like I used to, but 12% in order to compensate myself for the additional risk that I take. It makes perfect sense, and there’s nothing wrong with that.

Nevertheless, while many investors focus on the negative impact of interest rates on equities, fewer are likely to consider how rising rates can actually benefit their portfolios. In this article, I suggest that investors consider BDCs (Business Development Companies) in the current environment, whose lending operations may actually generate better results as interest rates rise.

How are BDCs actually benefiting from higher tariffs?

The way BDCs generate income is by lending funds and investing in private companies through equity, debt and other blended financial tools. A significant portion of the loans issued by the BDC are linked to variable rates. This means that the interest on these securities is determined by the underlying interest rates in the economy.

In fact, you’ll be surprised to learn that over 80% of loans in BDC’s portfolios are floating rate, which directly means that BDC is well positioned to see higher interest income in a rate hikes like the one we are currently taking.

However, there is a catch. BDCs also have to borrow money to invest their money. If a BDC’s interest income increases because of its issued floating loans, but the interest paid on its own borrowings increases by an equally large amount, that is not good. In other words, the desired effect of rising rates is not just an increase in interest income, but actually an expansion of BDC’s net income margin.

Let’s take two different examples.

This is Sixth Street Specialty Lending (NYSE: TSLX) net interest margin analysis from its latest Q3 presentation. As you can see, supported by rising interest rates, the company’s total return on its debt investments has increased for three consecutive quarters. It now stands at 12.2%. However, as the chart illustrates, the company’s cost of debt has since risen at a faster rate than the return on its investments. The result? Sixth Street’s average income gap did not grow and even narrowed between the second and third quarters, from 8.7% to 8.5%.

Next, here are the Owl Rock Capital Corporation (NYSE: ORCC) equivalent measures, taken from its presentation of third quarter results. Likewise, with rising rates increasing the company’s earning capacity, Owl Rock’s weighted average yield on its debt has increased significantly. However, with Owl Rock’s own borrowing not moving to higher rates as quickly, the company’s revenue gap actually increased. The year-over-year increase from 6.5% to 6.7% may seem insignificant, but a change of just a few basis points can have a big impact on a BDC’s bottom line.

So what is the conclusion to be drawn from this? You want to hold BDCs that have borrowed at low fixed rates and issued floating rate loans so that they benefit from the increased net interest margin resulting from higher rates.

BDCs have high returns, but be aware

BDCs are highly regulated. Due to their legal status, they are required to distribute more than 90% of their profits to shareholders. They do this because in return they don’t pay corporation tax on profits before distributing them to shareholders. The result is that most BDCs have massive returns that typically hover between high digits and double digits.

For illustrative purposes, I have compiled a list including the majority of BDCs, along with their respective yields.

Security NameTeleprinterDividend yield
Ares Capital CorporationCRAC9.02%
Barings BDC Inc.BBDC10.16%
Bain Capital Specialized Financing IncBCSF10.21%
Blackrock Capital Investment Corp.BKCC9.87%
Carlyle Secure Credits IncCGBD9.94%
Capital Southwest CorporationCSWC10.73%
First Eagle Alternative Capital BDC IncFCRD9.80%
Fidus investment companyFDUS7.06%
FS KKR Capital CorpFSK12.68%
Gladstone Investment CompanyGAIN6.37%
Golub Capital BDC IncGBDC9.22%
Great Elm Capital Corp.GECC19.38%
Gladstone Capital CorporationHAPPY8.25%
Goldman Sachs BDC Inc.GSBD11.49%
Horizon Technology Finance CorporationHRZN10.07%
Hercules Capital Inc.HTGC9.49%
Investcorp Credit Management Bdc IncICMB16.74%
Main Street Capital Corp.MAIN6.76%
Monroe Capital Corp.MRCC12.21%
Metrovacesa SAVMC5.45%
NEWTEK Business Services Corp.TRITON16.13%
New Mountain Finance Corp.NMFC9.66%
Oaktree Specialty Lending CorpOCSL9.33%
OFS Capital CorpFSO10.28%
Owl Rock Capital CorpORCC10.26%
Oxford Square Capital Corp.OXSQ13.42%
Pennantpark Floating Rate Capital LtdLTFP9.97%
Pennant Park Investment Corp.PNNT4.84%
Prospect Capital CorporationPSEC9.81%
Portman Ridge Finance CorporationRTMN11.35%
Rand Capital Corp.RAND3.05%
Saratoga Investment Corp.SAR9.13%
Stellus Capital Investment Corp.SCM8.05%
SLR investment companySLRC11.99%
BlackRock TCP Capital CorpTCPC8.72%
Venture Capital Growth Triplepoint BDC CorpTPVG11.64%
Trinity Capital Inc.TRIN19.21%
Sixth Street Specialty Lending IncTSLX9.77%
WhiteHorse Finance IncFPM10.48%

High yields can be quite attractive in today’s environment because they provide a margin of safety. Plus, you have greater visibility into what your future returns might look like. However, make sure that each respective dividend is well covered.

Many companies in the space have been cautious, which has resulted in no dividend cuts and even dividend increases over time. Check out TriplePoint Venture Growth BDC Corp. (NYSE: TPVG); this is a good example. Others overdistributed, causing their net asset value to deteriorate.

So, don’t be blinded by the limelight of ultra-high yields. This isn’t always true, but chances are the higher the return, the riskier it is. So try to strike a balance between the prospects of high total return and the actual risk you are taking. Happy BDC hunting!

Disclosure

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.