Rising short-term rates will likely provide an earnings boost to business development companies (BDCs) in the near term as LIBOR rates approach loan-specific floors, says Fitch Ratings.

BDCs are generally interest rate sensitive asmost investment portfolio assets earn floating rates based on one- or three-month LIBOR while funding is largely fixed rate. Of the 18 largest BDCs by assets, about 82% of portfolio investments, on average, earned floating rates at Sept. 30, 2016, reflecting the focus on senior secured assets, while 42% of total debt, on average, was fixed rate as of the same date. Additionally, about 58% of total assets are funded with equity, which is effectively a fixed-rate instrument.

While LIBOR has risen over the past 12 months, BDC net interest margins have been squeezed - most BDC loans have LIBOR floors of around 1%, while floating rate borrowing facilities have no LIBOR floor. Therefore, funding costs have increased while asset yields have had no benefit. The mechanism on floating rate assets will activate when the relevant LIBOR rate rises above 1%.

Link to Fitch charts and tables: https://www.fitchratings.com/site/pr/1016471

The prospect of LIBOR rising above 1% over the short term is looking increasingly likely with the three-month rate recently pushing above 0.9% for the first time since 2009. The one-month LIBOR rate has also risen significantly and is close to 0.7%. Market expectations of Fed policy rate hikes in late 2016 and 2017 also point to a continuation of the rising trend. As such, BDCs are much better positioned now to benefit from interest rate increases than a year ago.

BDCs generally disclose their interest rate sensitivities in financial filings in 100bps increments. While a 100bps increase from current levels may not occur until 2018, Fitch estimates that the average earnings upside from a 100bps increase in base rates from levels at end-3Q16 would be equivalent to 5.2% of net investment income for the 18 firms included in the analysis. This is up from an average of just 0.5% at the same point in 2015.

Golub Capital BDC, FS Investment, Ares Capital, Hercules Capital and TCP Capital are among the BDCs best positioned to benefit from rising rates (see link above). Additionally, Golub, Medley Capital, Ares Capital, TPG Specialty Lending and New Mountain Finance have seen the most improvement year over year.
 
While BDCs' balance sheet composition may allow for net investment income expansion, Fitch believes rising interest rates, beyond LIBOR floors, could also increase asset-quality issues at the underlying portfolio company level, if borrowers are unable to manage higher debt service burdens. On the other hand, if interest rate increases are gradual in nature and accompanied by a strengthening economy, revenue and EBITDA at the portfolio company level would be expected to benefit, which would make higher payment burdens more manageable.

Despite the potential earnings benefit from rising rates, Fitch maintains a Negative Sector Outlook for BDCs in 2017. Persistent challenges pertaining to competition, asset quality and dividend coverage, among other issues, will likely result in rating pressure for some BDCs next year.

Fitch also expects earnings to remain pressured by tight asset spreads and likely asset quality reversion from unsustainable lows. Recent efforts by BDCs to boost earnings, including moving down the capital structure of investments, cutting management fee rates, fee waivers, and the use of more levered off-balance sheet vehicles, have not been sufficient to prevent numerous dividend reductions in the sector.