Increased exposure to floating-rate investments and generally heavy use of fixed rate funding has positioned U.S. business development companies (BDCs) well to adjust to the rising rate environment longer term, according to Fitch Ratings. However, near-term earnings may be squeezed by slight upticks in interest rates, as many BDCs deal with interest rate floors on their floating-rate debt investments.

For some time now, BDCs, publicly traded lenders to middle-market companies, have moved to increase the share of floating-rate debt in their investment portfolios. Floating-rate instruments represented between approximately 35% and 80% of total investments for Fitch-rated BDCs as of June 30.

For BDCs with heavy exposure to floating-rate investments, rising rates boost interest income, profitability and dividend coverage. However, rates will generally need to rise at least 100 bp for BDCs to reap the benefits of the additional income, given the impact of interest rate floors. At the same time, heavy reliance on floating-rate debt can erode profitability gains as interest costs rise. The fixed floating funding mix for BDCs can fluctuate throughout the quarter as floating-rate revolvers are utilized for funding, prior to being paid down by fixed rate unsecured debt issuance.

Fixed rate funding for many BDCs has increased significantly over the past year given the attractiveness of the unsecured debt markets. As such, many BDCs have become less reliant on their secured floating-rate revolvers. At June 30, the average Fitch-rated BDC funding profile, excluding American Capital (ACAS), which is 100% floating-rate debt funded, was comprised of approximately 69% fixed rate debt.

An additional risk linked to rising rates is that portfolio companies may come under greater financial stress as interest payments on floating-rate debt increase. In general, however, Fitch believes that BDC underwriting teams have likely factored in these risks when originating deals. Portfolio companies' cash flows could also improve if rising rates signal some fundamental improvement in the economy.

Besides a focus on increased exposure to floating-rate investments, some BDCs have also chosen to hedge against the risk of rising funding costs through the use of interest rate caps for their revolvers and term loans.

Among the largest BDCs, Fitch believes Ares Capital Corp. (Ares) is well positioned to benefit from higher interest rates due to its heavier reliance on floating-rate investments (79% as of June 30) and use of fixed rate unsecured notes and convertibles (75% at June 30) for funding. At June 30, Ares reported that a 200 bp rise in interest rates would increase its annual interest income by $29.4 million, all else equal.