Position For Rising Rates with BDCs as Credit Concerns AbateCoulter Regal, CFA, Associate Product ManagerJuly 12, 2021
In the current low, and potentially soon to be rising, interest rate environment, Business Development Companies (BDCs) are an alternative income source investors should consider, when looking to enhance yield in their portfolios, without adding significant interest rate risk.
Credit Concerns In the Rear-View
BDCs generate income by lending to, and investing in, private companies that tend to be rated below investment grade or unrated, and are generally difficult to access. This private credit nature of BDCs, paired with their pass through tax treatment, has historically provided high income potential to their equity investors with yields often near double digits. However, these same investments in less mature and smaller private companies, can also lead to credit concerns in “risk-off” environments, as seen during the pandemic last year.
BDCs were hit hard during the first half of 2020 on credit concerns surrounding the pandemic and lockdowns however, they have since seen a significant recovery as the U.S. economy has reopened and economic data has been strong. In fact, BDC valuations, as represented by the MVIS® U.S. Business Development Companies Index (MVBIZDTG), have completely recovered to pre-pandemic levels. Additionally, and perhaps even more importantly, the portion of non-accrual status loans, or loans with overdue interest payments, in BDC portfolios have been falling over the last few quarters. The below chart shows falling non-accrual rates for some of the largest publicly traded business development companies.
BDC Non-Accruals at Cost
Source: BDC Quarterly Investor Presentations. As of 6/30/2021, Ares Capital Corp. (ARCC), Main Street Capital Corp. (MAIN) and Golub Capital Bdc (GBDC) were holdings in the VanEck Vectors BDC Income ETF, constituting 15.5%, 5.0% and 4.5% of the fund’s net assets respectively.
BDCs Are Positioned for Rising Rates
Despite the current low rate environment, potential rate hikes are on the minds of investors and interest rate fears are beginning to creep back into the market again as the U.S. Federal Reserve (the Fed) is no longer just “talking about” raising rates. Recent Fed comments signaled the potential for higher interest rates earlier than expected and rates on 10 Year U.S. Treasuries have already risen by almost 100 basis points since the lows of last year.
BDCs generate income based on their net interest margins, or the difference between interest income from portfolio investments and interest expense on borrowings/debt, and are well positioned to succeed in a rising interest rate environment with over 80% of loans, on average, in BDC portfolios featuring a floating rate.1 In fact, many BDCs actually stand to benefit from a rise in base interest rates thanks to these floating rate loans paired with the fixed low rate debt that BDCs issued over the last year. This means that as base interest rates increase, BDCs will likely see higher net interest margins and increased annual net income. As an example, the below table shows the projected impact of increases in base interest rates on interest income and expense for Ares Capital Corp., one of the largest publically traded BDCs.
Ares Capital Corporation Projected Impact of Base Rate Changes in Interest Rates
Change in Base Interest Rates Interest Income Interest Expense Annual Net Income Up 100 Basis Points $25M $15M $10M Up 200 Basis Points $146M $30M $116M Up 300 Basis Points $261M $46M $215M
Source: “Form 10-Q,” U.S. Securities and Exchange Commission, April 28, 2021.
As such, BDCs may serve as a complement to income allocations to help enhance yield without adding significant interest rate risk and may even benefit from rising rates. Investors can gain exposure to BDCs through the VanEck Vectors® BDC Income ETF (BIZD) which provides one trade access to publicly traded U.S. business development companies, providing diversification across the industry and alleviating the need for individual BDC credit research.
1 Sources: BDC financial statements as available on the BDCs comprising the MVIS® US Business Development Companies Index (MVBIZDTG). Data as of 3/31/2021.
The MVIS US Business Development Companies Index (MVBIZDTG) is a rules-based index intended to track the overall performance of publicly traded business development companies.
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Business Development Companies (BDC) invest in private companies and thinly traded securities of public companies, including debt instruments of such companies. Generally, little public information exists for private and thinly traded companies and there is a risk that investors may not be able to make fully informed investment decisions. Less mature and smaller private companies involve greater risk than well-established and larger publicly traded companies. Investing in debt involves risk that the issuer may default on its payments or declare bankruptcy and debt may not be rated by a credit rating agency. Many debt investments in which a BDC may invest will not be rated by a credit rating agency and will be below investment grade quality. These investments have predominantly speculative characteristics with respect to an issuer's capacity to make payments of interest and principal. BDCs may not generate income at all times. Additionally, limitations on asset mix and leverage may prohibit the way that BDCs raise capital. The Fund and its affiliates may not own in excess of 25% of a BDC's outstanding voting securities which may limit the Fund's ability to fully replicate its index. An investment in the Fund may be subject to risks which include, among others, investment restrictions, financial sector, small- and medium-capitalization companies, equity securities, market, operational, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount risk and liquidity of fund shares, issuer-specific changes and concentration risks. Small- and medium-capitalization companies may be subject to elevated risks.
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Authored byCoulter Regal, CFA
Associate Product Manager