The Most Important Thing for These High Yield Stocks

Photo: Lendingmemo.com

Any financial company, be it a bank or BDC, has two main earnings drivers: the cost of funds, and yields on their investments.

Today I wanted to look at the BDCs to compare funding costs from company to company. You'll find that how a BDC chooses to fund its balance sheet has a huge impact on its cost of debt, and its profitability.

Here's a table of 5 different BDCs, and their respective funding costs:

BDC Name

Weighted average cost of debt

Debt to equity ratio

Ares Capital Corporation (NASDAQ: ARCC  )

5.3%

66%

Prospect Capital (NASDAQ: PSEC  )

5.8%

60.7%

THL Credit (NASDAQ: TCRD  )

3.6%

49%

Main Street Capital (NYSE: MAIN  )

3.5%

66%

Triangle Capital (NYSE: TCAP  )

5.2%

79%

The table above shows little correlation between debt levels and interest costs. Although higher leverage generally means higher-risk for the lender (and higher interest for the borrower), the makeup of debt types has a more significant impact on a BDC's total funding costs.

Main Street Capital is an excellent example of a company that manages to keep its funding costs low. It borrows a significant portion of its funding from the Small Business Administration and a credit facility at 3.8% and 2.4% respectively. Likewise, THL Credit sources funds from a term loan and revolver, reducing its interest expense to just 3.6% on average.

Higher cost borrowers, like Ares Capital, Prospect Capital, and Triangle Capital, source proportionately more of their funding in the form of long-term debt. Ares Capital, for example, sourced roughly 7% of its debt funding from a credit facility -- the remainder comes from a variety of higher-cost, long-term notes. Prospect Capital didn't use a dime of its credit facility as of its last earnings report. Triangle Capital sourced just under 3% of its borrowings from its credit facility. Notice a trend? When BDCs aren't using their credit facility, their debt costs soar. 

But there is plenty of upside, too. Unused credit facilities, when turned back "on," allow a BDC to cut down its cost of funding and grow its net interest margin.

Why it matters
Yields are falling for most BDCs as more capital flows into the markets in which they invest. But what really matters isn't the rate BDCs earn on their investments. What matters is the spread -- the difference between their funding costs and portfolio yields.

As investment yields decline, those with the highest funding costs will see the biggest change in their earnings over time. They'll have only a few choices: accept more investment risk, or start seeking out lower-cost debt funding. It's just that simple. Earnings reports are only one month away. I'll be paying attention to the companies that are making creative moves to lower their cost of debt. You should be, too. 

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