Prospect Capital (NASDAQ: PSEC) is primarily a lender. The majority of its assets are floating-rate loans. These loans pay a rate of interest based on LIBOR. The higher LIBOR rises, the more money Prospect Capital should earn in interest on its loan portfolio.
Prospect Capital's liabilities are also important to any discussion about interest rates. As of its most recent report, the vast majority of Prospect Capital's liabilities (89%) are fixed-rate. Its credit facility makes up virtually all of its floating-rate liabilities -- $317.7 million as of March 31.
Some investors believe that rising rates are inherently good for Prospect Capital, but in fact, a small increase in rates would have a negative impact on its earnings power. The company needs a substantial increase in rates to see a boost in its earnings.
A look at floors
When Prospect Capital makes a floating-rate loan, it generally structures the loan with a LIBOR floor.
A loan might pay LIBOR plus 8%, with a LIBOR floor of 3%. In this case, when LIBOR is below 3%, the loan will yield 11% (8% plus the floor rate of 3%). If LIBOR were 4%, then the loan would yield 12% (8% plus LIBOR of 4%).
Rising interest rates drive interest income higher only when LIBOR exceeds the floor written into the loan.
I looked at every single loan in Prospect Capital's book to find its floor rate. The chart below shows the distribution of its LIBOR floors in its floating-rate loans.
Most of its floating-rate investments (more than 99% by fair value) have a floor greater than 1%. Thus LIBOR, as measured by one- and three-month LIBOR, will need to rise above 1% for rising rates to have any meaningful impact on Prospect Capital's profitability.
Currently, one- and three-month LIBOR sit at 0.19% and 0.28%, respectively.
Prospect Capital's credit facility has no LIBOR floor. If rates rise, Prospect Capital could pay more in interest than it earns in incremental interest on its floating-rate loan portfolio. Based on my research, I believe the breakeven point is around 1.2%. At that level, the additional interest it pays on its credit facility would be offset by additional interest earned on its loan portfolio.
The hidden variable
So far, I've looked only at Prospect Capital's floating-rate loans, which make up the majority of its balance sheet.
Prospect Capital's collateralized loan obligation equity also has exposure to rising rates. CLOs use floating-rate liabilities to fund investments in floating-rate loans. But like Prospect Capital's on balance sheet investments, CLO liabilities generally do not have floors, though their assets do. Thus it would be reasonable to suspect that, in the short term, small increases in rates would have negatively affect the earnings power and value of Prospect Capital's CLO investments. How much of an impact they would have is virtually impossible to know.
Given that CLOs make up roughly 16% of Prospect Capitals investments, and floating-rate loans making up another 67% of its investments at fair value, a full 83% of its investments could be adversely affected by a small increase in short-term rates.
If 2015 turns out to be the year of the first rate increase, the company's profitability may drop modestly as a result. Based on my research, I believe that only when LIBOR surpasses 1% will Prospect begin to enjoy an offsetting increase in its returns on its loans. Depending on your view of interest rates, an environment in which LIBOR rests above 1% could be far down the road.
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.