One of the best reasons to own high-yield business development companies like Apollo Investment (NASDAQ:AINV) and Fifth Street Finance (NASDAQ:FSC) is that they should benefit from rising rates. Since most BDCs invest in floating-rate debt, rising rates should drive their asset yields higher. Rising dividends should follow.
But there could be more to the rising rate story than meets the eye. Some BDCs need much larger increases in rates than others because their investments have LIBOR floors.
Mind the LIBOR floor
LIBOR floors effectively function as a minimum interest rate for calculating the interest due on a floating-rate loan. Here is an example.
Suppose a floating-rate loan pays interest equal to LIBOR plus 6%, 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, the loan would yield 6% plus the floor rate of 3%, for a total of 9%.
- 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 yield 6% plus 5%, or 11%.
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 9%. Thus, LIBOR needs to rise massively in today's low-rate environment to affect the example loan.
How rate-sensitive is my BDC?
Virtually every BDC publishes a rate sensitivity table in their SEC filings. Unfortunately, most of these sensitivity analyses are self-serving. Some BDCs go so far to show only what would happen if rates were to rise by 5%, for example.
I like more detail -- a little more granularity. After all, it's unlikely that rates will simply shoot from less than 1% to 5% or more.
To create this granularity, I compiled the LIBOR floors on every single one of Apollo Investment's and Fifth Street Finance's portfolio companies. Then I put these investments in piles, and summed up their fair values by LIBOR floor.
The result is the chart below:
You can make quick work of the logic behind the chart above. Apollo Investment needs a smaller increase in LIBOR than Fifth Street to generate a larger return on its floating-rate investment portfolio.
Roughly 18% of Apollo's floating-rate portfolio does not have a LIBOR floor, so any increase in LIBOR will result in more interest income. On the other hand, only 8% of Fifth Street Finance's floating-rate portfolio does not have a floor.
Also notice that the difference between these BDCs evens out as you move up through the floors. Roughly 55% of each company's floating-rate portfolio would stand to benefit once LIBOR crossed 1%. There is a plurality of conclusions to be drawn from the chart above, but the one-month and three-month LIBOR readings should help put the chart in perspective.
- One-Month LIBOR: 0.16%
- Three-Month LIBOR: 0.24%
The net effect
As investors think about the future for interest rates, BDC investors should pay close attention to a company's exposure to floating-rate debt. And where floating-rate loans are most prevalent, careful study of LIBOR floors is important.
After all, rate hikes will likely come in the form of slow and methodical increases. Business development companies that fund themselves with fixed-rate debt and which have the most exposure to low-floor floating-rate loans will be the biggest winners.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Apollo Investment.. 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.