The Fed's quantitative easing program was designed to drive down long-term interest rates. The opposite -- the taper -- is designed to allow long-term rates to rise. 

I wanted to take some time today to look at how the taper will affect business development companies, high-yield stocks that make money by lending to and investing in middle-market businesses.

Later in the article, we'll examine the interest rate sensitivity of Main Street Capital (MAIN 0.82%), First Street Finance (NASDAQ: FSC), Prospect Capital (PSEC 0.83%), and Ares Capital (ARCC 0.10%)

BDCs in a nutshell
Business development companies rarely make long-term, fixed-rate loans. Most are built around one- and three-month LIBOR rates. As LIBOR rises or falls, BDCs generate more or less income from their debt investments.

So what does it take to move LIBOR up or down?

I went back through historical LIBOR data to seek a correlation between LIBOR and other interest rate indexes. Of the various indexes, LIBOR is most correlated to the federal funds rate, or the rate at which banks lend to one another overnight.

Here's a chart comparing one- and three-month LIBOR to the federal funds rate:

 

The Y-axis in the chart above is mostly irrelevant. What's important is how closely one- and three-month LIBOR rates follow the federal funds rate. Only during periods of distress do LIBOR and the fed funds rate deviate. Distrust in the banking system led to higher LIBOR rates during the financial crisis, but once confidence was restored, LIBOR went back to its normal pattern.

Taper vs. fed funds
When the Fed buys U.S. Treasuries and mortgage-backed securities to drive down rates, it's operating on the long end of the yield curve. The federal funds rate isn't something that moves with the taper. Rather, it's a completely separate matter altogether.

In a recent board meeting, Federal Reserve policymakers reported that they would be comfortable holding the federal funds rate low, even after unemployment reaches the Fed's target of less than 6.5%.

So, even if the taper results in a 1 percentage point move in long-term rates, it will have virtually zero effect on LIBOR, and substantially no effect on a BDC's bottom line.

Who's making the grade?
Most BDCs will soon report earnings, and their balance sheet composition will have invariably changed, but we can look to the most recent quarterly results to measure a BDC's rough interest rate exposure. 

BDC

Percentage of Debt Investments With Floating Rates

Main Street Capital

50%

Prospect Capital

89%

Ares Capital

82%

Fifth Street Finance

67%

As you can see, virtually all BDCs have something to gain from a significant increase in short-term interest rates. Prospect Capital and Ares Capital have the biggest floating rate portfolios, while Main Street Capital and Fifth Street Finance are fairly diversified between fixed- and floating-rate investments.

It's important to recognize, however, that for a BDC to benefit from rising rates, LIBOR would have to jump by an amount that can be measured in full percentage points.

Prospect Capital notes that nearly all of its loans have LIBOR floors starting at 1.25%. Fifth Street Finance reported that 90% of its loans have LIBOR floors above 1%. Ares Capital's interest rate sensitivity requires a 2 percentage point jump in LIBOR for an increase in net investment income. (A 1 percentage point jump would cost Ares Capital about $23 million per year.)

The bottom line is that tapering has little effect on BDC's profitability, and it won't be until the fed funds Rate crosses 1-2%, and LIBOR rates follow, that BDCs see a significant change in earnings on their floating-rate investments. So, while BDCs have moved their portfolios to gain from rising rates, we're still a long way away from interest rates driving earnings growth for the industry.