One draw of BDCs is that they tend to hold a majority of their assets in floating-rate debt. Thus, as rates rise, so should a BDC's portfolio yield, and its dividends. But don't be so quick to accept this at face value.
Some nuances affect a BDC's exposure to rising rates, leaving smaller BDCs ill-equipped to handle rate increases.
Two tiny companies with big yields
Two smaller companies, Medley Capital (NYSE:MCC) and THL Credit (NASDAQ:TCRD), hold a majority of their portfolios in floating-rate debt. Medley reports that roughly 66% of its income-bearing assets are floating rate. THL Credit discloses that 63% of its assets are floating rate.
Taken at face value, these look like excellent plays for rising rates.
What most BDCs don't break out, though, is how high rates will have to rise before it affects their portfolios. Most middle-market loans have LIBOR floors. Thus, only when LIBOR crosses a floor -- or a minimum interest rate -- will BDCs begin to collect yields on their investment portfolios.
By compiling data from every single loan held on a BDC's balance sheet we can see how exposed a BDC is to rising rates.
The chart below shows what percentage of each BDC's floating-rate assets fit within various floor levels:
You can quickly see how Medley Capital and THL Credit differ by their interest rate exposures.
A significant portion (roughly 18%) of Medley's portfolio does not have a floor in place. Thus, with every increase in rates, Medley stands to benefit on these loans. And over two-thirds (roughly 68%) have LIBOR floors less than or equal to 1%, meaning that two-thirds of its loans will yield more when LIBOR rises above 1%.
On the other hand, THL Credit will require much more significant increases in rates to drive interest income. All of its floating-rate investments have LIBOR floors. And a majority of those investments need LIBOR to move toward and above 1% before the company benefits at all. Right now, one-month and three-month LIBOR are both below 0.25%. The move to 1% is a very significant one, which may take months, if not years.
The flip side
Medley Capital and THL Credit, are relatively small in the world of business development companies. As such, their funding costs tend to be higher, and their choices for balance sheet funding are limited.
Unfortunately, this means that a majority of their borrowings are floating rate. Thus, their borrowing costs will rise with LIBOR, and initially their costs will rise faster than the income from their portfolios.
Medley Capital points out that rising rates would help its overall profitability when rates rise two percentage points. THL Credit's portfolio needs rates to rise by three percentage points before the added yield overcomes the added cost of borrowings.
Larger BDCs, which have the benefit of using low-cost, fixed-rate debt tend to have the best interest rate exposures as their investment yields will rise with minimal impact to their funding costs. All in all, if you like BDCs for the floating-rate exposure, you may be better suited for some of the larger industry players that have fixed borrowing costs, rather than a company like THL Credit or Medley Capital.
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.