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%.
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.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.