Rising Interest Rates Don't Scare These BDCs

The hunt for yield has led many investors to the doorsteps of mortgage REITs and business development companies, both of which are legally required to hand over 90% of their profits to shareholders in order to enjoy special tax status. With few exceptions, such as American Capital (NASDAQ: ACAS  ) , these BDCs often pay out healthy dividends, providing double-digit yields similar to many mREITs.

But, the market madness that has ensued since the Federal Reserve's last meeting and Chair Ben Bernake's public comments has thrown cold water on the mREIT sector -- and given BDCs a bruising, too.

The current environment might make some investors wonder whether or not BDCs are still a good bet. Here are some things that these companies have been saying about how they plan to weather the current storm -- as well as future interest rate hikes.

Protection against higher interest rates
As lenders to companies on sometimes less-than-stable footing, BDCs certainly have some risk ingrained in their portfolios. But income-seeking investors have made the sector popular, and much like mREITs, the number of BDCs has exploded -- Reuters notes that just nine years ago, there were only four, compared with the 30 that exist today. Unlike mREITs, though, leverage is usually much lower, and many sport a debt to equity ratio of 1:1. 

With higher interest rates in the air, some of these companies point out that they have taken steps to plan for just such an occurrence. Fifth Street Finance (NASDAQ: FSC  ) , in its June newsletter, tells its investors that its portfolio stands to gain from an upswing in short-term rates, since the loans they make tend to be of the floating rate variety, and the company's borrowing costs are fixed.

Similarly, Prospect Capital (NASDAQ: PSEC  ) recently announced the next four months' worth of dividends, showcasing a yield of 12.7%. Further, management noted that its liabilities are locked in for the next 30 years, while its loans float with LIBOR, putting them in the catbird seat as far as rising interest rates are concerned.

And, what of American Capital, the BDC with no dividend? For its part, management plans to continue with its robust share buyback program, noting that it plans to take advantage of the lower stock price and outflow of investors by grabbing up some more shares. Last year, American Capital spent over $100 million in this manner, to good effect. Now that book value has fallen again, management sees a prime opportunity to bolster its drooping book value by purchasing more shares, rather than putting funds into new investments.

So far, this plan has gone a long way toward increasing the company's stability: CEO Malon Wilkus notes that American Capital, once debt-heavy, has paid down more than $6 billion in debt over the past five years. Though first-quarter earnings showed losses on earnings and revenue, book value increased 7%.

Interestingly, management sees competition among the 40-plus BDCs, by their count, now in existence as more of a threat than interest rate -- though American Capital's diverse business model should be able to help dilute risks in both areas.

Know the risks
Though each of these companies are taking the necessary steps to thrive throughout the QE3 taper and exit, the inherent risk in this particular business model might make some investors nervous. While Prospect Capital's recent presentation makes note of its tendency to gravitate toward more high-quality lending laden with lender protections, not all may be as discerning.

This past March, an analyst from Wells Fargo (NYSE: WFC  ) voiced two major concerns regarding the sector: higher leverage, and the increasing involvement in covenant light loans, with few or no safety clauses for lenders and investors. Knowing how a particular BDC runs its business can go a long way toward alleviating investor worries, especially during times of market upheaval.

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