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AAM Viewpoints – As Rates Move Higher, Business Development Companies Differentiate Themselves


The strength of the U.S. economy is undisputed and, ironically, for income-seeking investors this can present some challenges. As the economy grows inflation will ultimately tick higher, interest rates will follow, as well as a subsequent adjustment to the prices of assets that trade as a function of interest rates. Or, as we are all more familiar with in the income world – as rates go up, prices go down.

We have seen this scenario play out over the last year. U.S. GDP (Gross Domestic Product) grew 2.9% YOY (year over year) and 4.2% quarter over quarter through the end of June. Core CPI (Consumer Price Index) hit a 10-year high of 2.4% growth YOY in July. The yield on the U.S. 10-year Treasury has more than doubled from its low of 1.36% on 7/8/2016, rising 184 bps (basis points) to 3.20% (as of 10/17/2018).

The increase in interest rates has long been expected and the pressure on fixed-income investments, bond proxies, and alternative income investments comes as no surprise. The tables below show the current yield and performance data for a select group of representative indices since the yield on the 10-year Treasury hit its all-time low in July 2016.


10-Year U.S. Treasury Yield

7/8/16

1.36%

10/18/18

3.20%

Source: Bloomberg


Asset Class

Current Yield

Price Return

Total Return

Dates

10/17/2018

7/8/16 - 10/17/18

7/8/16 - 10/17/18

Bloomberg Barclays US Treasury Index

2.40%

-9.26%

-4.85%

Bloomberg Barclays US Aggregate Bond Index

3.22%

-8.19%

-2.16%

Bloomberg Barclays US Municipal Bond Index

4.45%

-9.15%

-0.04%

MSCI US REIT Index

4.52%

-10.96%

-1.95%

S&P Preferred Stock Index

5.75%

-9.45%

4.41%

Alerian MLP Index

7.85%

-13.63%

2.05%

Wells Fargo BDC Index

9.43%

-4.86%

17.10%

Source: Barclays, Bloomberg | Past performance is not indicative of future results.

As can be seen above, one asset class that carries an above average yield clearly stands out in this rising rate environment: Business Development Companies (BDCs).

What are BDCs?

In 1980, Congress created BDCs to provide retail investors with the means to invest in the growth of private U.S. businesses. BDCs invest primarily in private, middle-market companies that do not have access to traditional capital markets due to their size and/or risk profile via debt and equity instruments. BDCs manage this risk by selectively originating their investment portfolio and diversifying their source of funds, industry exposure, geographical profile, and capital structure.

BDCs are regulated as a Business Development Company under the Investment Company Act of 1940. Generally, BDCs elect to be treated as a Regulated Investment Company (RIC) for U.S. federal income tax purposes which requires them to distribute at least 90% of investment company taxable income to shareholders to avoid corporate income tax on distributed taxable income.

Why are BDCs performing better than other income-producing assets?

BDCs are actively managed and can adjust their capital structure to benefit from an expected rise in interest rates. That’s right – as rates go up, prices (net asset values) can go up. To accomplish this, if management expects base interest rates to rise they can structure future investments to borrow at a fixed-rate and invest those funds in floating-rate loans (typically tied to LIBOR.) The higher interest rates go above the fixed-rate cost of capital, the higher the net interest margin. This can lead to increased earnings which support and grow distributions and can increase the book value of the portfolio.

Management teams have been able to capitalize on the rising interest rate environment by tactically positioning their balance sheet. Looking at the five largest BDCs by market cap, current investment portfolios are 81% floating (variable) rate on average. To illustrate this effect, some BDCs outline different interest rate scenarios and the subsequent impact on their share price. For example, Ares Capital Corporation included a table in their second-quarter 2018 earnings presentation with the following information:


Ares Capital Corporation

Increase in LIBOR

Annual Per Share Impact

100 bps

$0.17 per share

200 bps

$0.33 per share

300 bps

$0.50 per share

 Source: Ares Capital, 6/30/18

They estimate that as interest rates rise it will have a positive impact on their investment income per share. We believe it is this flexibility that differentiates BDCs from other income-producing assets and has been the key driver of strong relative performance for the asset class over the last two years as interest rates have begun to move higher.

The robust business climate appears to be carrying over to the investment portfolio companies as well, using the low default rates as a gauge. Referencing the five largest BDCs as an example, the average non-performing loan (or non-accrual) rate is 1.6%, lower than the Moody’s global speculative-grade bond default rate of 2.9% through the end of June. Additionally, Standard and Poor’s currently rates each of the five largest BDCs investment-grade with a credit rating of BBB- or above.


Ticker

Name

Floating Rate

Non-Accrual Rate

S&P Credit Rating

ARCC

Ares Capital Corporation

91%

2.70%

BBB-

PSEC

Prospect Capital Corporation

90%

2.50%

BBB-

MAIN

Main Street Capital Corporation

75%

1.20%

BBB-

CCT

Corporate Capital Trust, Inc.

81%

1.50%

BBB-

FSIC

FS Investment Corporation

70%

0.20%

BBB-

Average

81%

1.6%

 

Source: Quarterly reports, 6/30/18

Going forward the inflation/interest rate environment will likely remain elevated including additional rate hikes by the Federal Reserve. This will continue to be a challenge for income investors and managing interest rate risk will be crucial over this cycle. Business Development Companies differentiate themselves from most other income-producing assets because they can tactically position their portfolios to benefit as rates move higher. While this is a relatively small segment of the market it has been a standout performer over the last two years and presents a unique opportunity for investors going forward that we believe is worth considering.

 

CRN: 2018-1002-6924 R

BDCs are generally leveraged which may magnify the potential for gains and losses on amounts invested which increases the risks associated with those securities. BDCs generally depend on the ability to access capital markets, raise cash, acquire suitable investments and monitor and administer those investments in order to maintain their status as BDCs and achieve their investment objectives. A failure to do so may adversely affect the value of the BDC shares. BDCs often invest in securities that are not publicly traded which adversely impacts their ability to value those assets and reduces the investments’ liquidity.

BDCs are closed-end funds which tend to trade at a discount from their net asset value and are subject to risks related to factors such as the manager’s ability to achieve a fund’s objective, market conditions affecting the fund’s investments and use of leverage.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.

 

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