The mantra investors often here about the BDC sector is that it is poised to benefit from a rising inflation environment. This is because the sector tends to hold floating-rate instruments which will generate a higher level of income as the Fed starts to hike the policy rate.
However, the reality is more complicated. First, the link between higher inflation and higher Fed policy rate is less direct than it used to be with the adoption of the new averaging inflation framework by the Fed. The clearest sign of this development is the fact that inflation currently hugely exceeds the Fed’s assumed target of 2% and yet the Fed plans to keep the policy rate on hold for at least another year, if not longer.
Secondly, the presence of Libor floors in BDC assets and their absence in BDC debt means that many BDCs will see a drop in income as short-term rates rise because interest expense will grow faster than investment income.
For many BDC income levels to grow decisively the Fed will need to hike around more than 4 times. So, a key risk for BDC investors is that the Fed hikes only 1-2 times and stops there for a period of time. In this case many BDCs will see lower income, a drop in coverage and likely lower prices (as they adjust to lower income levels) and, potentially, dividend cuts.
Over the last 40 years, the Fed Funds rate has topped out at decreasing levels which suggests that the US economy has been able to withstand fewer and fewer number of policy rate hikes before being pushed into a recession or a crisis of some kind. Of course the unexpected COVID shock of 2020 had nothing to do with the path of Fed hikes, however, the curve had already begun to invert in August of 2019 which suggests that the US economy was expected to tip into a recession, or at least, a slowdown by then anyway. This suggests that the risk of only a few rises in the policy rate this time around is very real.
In this article we use the Owl Rock Capital Corp. (ORCC) as a case study of the dynamic of lower income levels in the initial stages of higher policy rates. This is for the simple reason that it was recommended elsewhere based on the simplistic view that the company’s high floating-rate portfolio provides protection against rising inflation and, by implication, higher Fed policy rates.
BDCs, Inflation and Interest rates
In this section we take a look at the links between inflation, interest rates and BDC incomes. The basic view seems to be that higher inflation will automatically translate into a higher Fed policy rate which will automatically translate into higher BDC income.
There are two separate issues to dissect. The first issue is the link between inflation and the Fed policy rate and the second is the link between the higher policy rate and BDC net investment income.
On the first issue, the link between rising inflation and higher policy rate is not as clear-cut as, perhaps, it used to be. The Fed has a dual mandate – price stability and maximum sustainable employment. So, if the Fed finds itself in a stagflationary environment – that of rising inflation but weak economic activity – it is not at all clear that it will choose to hike interest rates as it is likely to even further depress macro activity.
It is also important to recall the Fed’s new inflation policy. The previous undeclared but widely assumed policy was that the Fed would target inflation of 2%. The new policy is that the Fed will target 2% over a period of time. What this means is that we should not expect the Fed to hike rates as soon as inflation rises above 2%. If anyone had any doubt about this new policy we only have to look at the fact that the year-on-year core PCE price index has more than doubled to 3.6% – a level obviously in excess of the 2% target.
This is happening at the same time when the Fed has indicated it is not in a rush to hike rates. With the departure of Boston Fed President Rosengren is likely to shift the first hike to 2023 from 2022.
Source: Blooomberg
In short, the link between rising inflation and higher policy rates is much more muddled these days than the superficial analysis suggests.
Let’s take a look at the second issue – that of between rising policy rate and higher BDC net investment income. The problem with this view is that it ignores the impact of rising rates on the liability part of the balance sheet, the impact of Libor floors and any hedges, level of leverage, actual debt composition and other issues.
One key reason why the link between rising the policy rate (and, hence, 3-month Libor which anchors most BDC loans) and net investment income is much weaker than commonly believed is because loans held by BDCs have Libor floors. For example, a loan that pays 3-month Libor + 7% with a Libor floor of 1% will continue paying the same 8% until Libor rises above 1%. With Libor currently at 0.13% that should take around 3 hikes at least. Libor tends to trade slightly higher than Fed Funds with the so-called Fed Funds / Libor basis driven by the near-term expected path of the policy rate as well as the unsecured / longer-term nature of Libor. However, because BDC floating-rate liabilities lack Libor floors, it means that most BDCs will see their liability cashflows (e.g. interest expense) increase at a faster pace initially than their asset-side cashflows (e.g. investment income) causing a drop in net investment income. In the section below we take a look at this dynamic with ORCC as a case study.
A Look At ORCC
Let’s take a look at ORCC as an example as it is one BDC that was recently recommended elsewhere with the view that its income was going to increase with the rise in the Fed policy rate.
ORCC discloses the sensitivity of its investment income and debt expense to rises in Libor in its SEC filings. The latest 10Q shows that the company’s net income will actually fall for a rise in Libor up to (at least) 100 basis points or 1%. This is due to the fact that the company’s weighted-average Libor floor is 0.9%.
Presented as a chart we see that the company’s interest expense (grey bars) grows at a faster pace than its investment income (orange bars), resulting in a drop in net income (blue bars) for the first 1% in the rise in Libor.
Source: Systematic Income, ORCC
Let’s see what this means in terms of net investment income.
Source: Systematic Income, ORCC
For a 0.5% rise in Libor (roughly equivalent to 2 Fed hikes) the company’s NII / share is expected to fall from $0.304 to $0.276 – drop of over 9%, all else equal. For a rise in Libor of 1%, NII is still down about 5% from current levels though it is less in a hole as some of the company’s debt investments have moved above their Libor floors. It is not entirely clear when the company’s NII moves above its starting point of $0.304 though it looks like it would be around Libor of 1.1% which is nearly 1% above its current level – an equivalent of roughly 4 Fed policy hikes.
If we go back to the Fed dot plot above we see that the Fed itself expects to reach this level in the policy rate sometime in early 2024 and market expectations based on Fed Funds futures don’t actually reach that level until some time in 2025. That is how long it is expected to take for the company’s NII to reverse a drop and claw back to its original starting level.
Let’s see what this means from a NII yield perspective. A rise in Libor to 0.5% pushes the NII yield (based on current price) from 8.56% to 7.77% which rises to 8.14% once Libor reaches 1%.
Source: Systematic Income, ORCC
Of course, NII yield is not the same as dividend yield and ORCC could very well keep its dividend the same through the period especially if the outlook is for a relatively fast trajectory of hikes. However, at a 0.5% rise in Libor the dividend coverage will drop around 9% to 89% which is not only an uncomfortable level but would also require the company to finance its dividend by either an increase in borrowing or a sale of assets which would further dent its NII.
There are two additional points worth mentioning. First, it is not enough to reach the expected date where the company NII rises above its current value – investors will need additional time to break even or claim back the lost NII when Libor was pushing through the 0-1% range which can take a significant further amount of time.
And secondly, a big risk for investors is that the Fed pauses in the window of 0.5-1% for an extended period of time, perhaps due to macro headwinds generated by a tighter credit regime. This will increase the period of time investors are earning a lower level of NII from their starting level.
We should also mention a number of other NII drivers that investors should keep in mind. One is interest rate hedges which can change the fixed-rate profile of a given security from fixed-rate to floating-rate or vice-versa. In the case of ORCC, the company swaps three of its unsecured notes from a fixed-rate to a floating-rate profile. What this means is that ORCC will have higher debt expense once Libor starts moving higher than had it not set up these hedges. Of course there are other benefits to these hedges such as an all-in lower rate due to the steepness of the yield curve. For example, rather than paying 2.625% on its 2027 notes ORCC currently pays around 1.785% (3-month Libor + 1.655%). Obviously, this rate will increase as Libor moves higher.
Source: 10Q
Other secondary factors for investors to consider is the change in portfolio leverage, debt composition and other factors though the dynamic of Libor floors remains the most important.
It can be tempting to think that the dynamics of Libor floors don’t really matter from a big picture perspective because the Libor floors provide “free money” so long as Libor is below its individual floors across the portfolio. This isn’t the right way to think about it since the pricing of spread over Libor is a function of the floor. In other words, it’s not correct to think that a loan paying Libor + 7% with a Libor floor of 1% generates windfall income so long as Libor remains below it floor. The floor has obvious economic value and would have been negotiated by the BDC with its borrower in relation to the spread over Libor. So, a loan without a Libor floor may have been executed at Libor + 7.5% – pricing that would generate a higher level of income than Libor + 7% with a 1% Libor floor when Libor is above 0.5%.
Takeaways
The key takeaway in this article is that details matter and investors who are relying on their BDC holdings for inflation protection and/or higher income from higher policy rates need to be aware of the actual dynamics of net investment income of their individual BDC holdings.
Another takeaway is that some BDCs face a headwind for their income if the Fed makes a pause after only 1-2 hikes which can leave the BDC, such as ORCC, with a lower income level for a significant period. This can have a knock-on effect of forcing the BDC to borrow or sell assets to finance its dividends which would have a further impact of increasing debt expense or decreasing investment income, potentially resulting in dividend cuts.
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