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How an Interest Rate Hike Could Impact Closed-Ended Funds

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Altering of portfolios

Closed-ended funds (PSP) deploy leverage in order to generate returns for shareholders. The method works in tandem when interest rates are low. As interest rates are expected to rise, the companies with highly leveraged portfolio investments will see lower returns due to higher interest costs. The higher risk will result from declining cash flows due to higher interest rates.

The Fed is expected to raise long-term interest rates in December. Short-term interest rates will remain low. The industry is expected to borrow and roll over on the short-term basis in order to reduce interest costs. However, a sizable portion will be raised on a long-term basis in order to match funding as well as maintain credit ratings.

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The selection of portfolio companies will also be impacted, as funds may prefer companies with less leverage in order to secure their interest and principal payouts. Companies are expected to deploy less capital in structured credit and low-grade credit as interest rates rise. Companies might deploy more capital in the form of equity or senior credit in order to reduce risk on investments.

Early redemptions

Prospect Capital (PSEC) successfully reduced its cost of debt to 5.7% in the September quarter compared to a cost of debt of 6.3% in the September 2014 quarter. Ares Capital (ARCC) has completed early redemption for $200 million of the aggregate principal amount of unsecured notes that were originally scheduled to mature in 2040. The company is funding these redemptions by borrowing under a revolving credit facility. A continuation of this could result in $0.03 benefit per share on an annualized basis.

Asset managers with higher leverage such as Apollo Investment (AINV) and United Rentals (URI) have focused on replacing their high-cost debt with lower costs in order to boost returns.

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