Part of the attraction of business development companies is that their assets are mostly floating-rate loans. Thus, should rates inevitably rise, a BDC's dividend should follow.

At least, that's what we're told. In all reality, most of the floating-rate loans on any BDC's balance sheet have LIBOR floors that affect a BDC's ability to capitalize on rising interest rates.

How LIBOR floors work
Libor floors effectively function as a minimum interest rate for calculating the interest due on a floating-rate loan. An example may help.

Suppose a floating-rate loan offers interest equal to LIBOR plus 8%, with a 3% LIBOR floor. 

  • If LIBOR is less than 3%, the LIBOR floor will be used in calculating the interest rate. In this case, a loan would yield 8% plus the floor rate of 3%, for a total of 11%.
  • If LIBOR is greater than the 3% floor, the actual LIBOR rate will be used in lieu of the floor. So, if LIBOR were 5%, the loan would 8% plus 5%, or 13%.
As you can see, a floor effectively negates some of the impact of rising rates. Only when LIBOR rises above 3% will our example loan yield more than 11%. 

But that's an example. To demonstrate the real impact of LIBOR floors on a BDC's portfolio, I compiled loan data from Prospect Capital (NASDAQ:PSEC) and Ares Capital (NASDAQ:ARCC), two of the largest BDCs on the market.

I put each loan in a pile, based on its floor. Then I summed the fair value of each loan, based on its floor. The result is the chart below:

As you can see, roughly 33% of Ares Capital's floating-rate loans have no floor, compared to fewer than 1% for Prospect Capital. With no floor, any increase or decrease in LIBOR affects the yield on those loans.

There is a very clear difference in rate exposure for Prospect Capital and Ares Capital. Virtually all of Ares' floating-rate loans have floors of 1.5% or less. And more than three-fourths of its loans will begin to pay bigger yields when LIBOR moves above 1%.

On the flip side, a majority of Prospect Capital's loans have floors of 1.5% or more. Thus, it won't be until LIBOR crosses 1.5% that yields on most of Prospect Capital's loan book would go up. Nearly 80% of its floating-rate loans need LIBOR to cross 1% before Prospect Capital would enjoy any extra yield.

Making sense of the differences
I compared Prospect to Ares because they are very similar. Both hold primarily floating-rate investments. Neither have any floating-rate debt outside of their short-term credit facilities, so rising rates would have a similar (minimal) impact on their borrowing costs.

As the Federal Reserve considers rate hikes, a BDC's exposure to floating-rate loans, and their LIBOR floors, will be more important than ever. One would expect that short-term rates would rise very slowly -- the one-month LIBOR has been "stuck" under 0.25% for a long time. Thus, the BDCs which have exposure to the lowest floors would be the first to benefit from rising rates.

The point is that floating-rate loans matter insofar as the floating-rate loans have low floors. High interest rate floors effectively eliminate much of the immediate advantage of exposure to floating-rate loans, and thus investors should pay close attention to the BDCs which have the lowest floors on their investments.