Closed-ended funds (PSP) deploy leverage in order to generate returns for shareholders. The method works in tandem with interest rates when they’re low. As interest rates rise, companies with highly leveraged portfolio investments see lower returns due to higher interest costs, and higher risks result from the declining cash flows that come from higher interest rates. However, given the decline in equities so far in 2016, the Fed is still expected to raise rates slowly.
The US Fed raised the federal funds rate by 25 basis points in December 2015. Since then, global markets have been weak and declining on China’s slowdown and lower oil prices. Meanwhile, closed-ended funds are 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.
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, and companies might deploy more capital in the form of equity or senior credit in order to reduce risk on investments.
Redemptions and buybacks
Prospect Capital’s (PSEC) cost of debt is approximately 5.6%, compared to above 6% last year. It achieved this reduction by repaying certain higher-cost debts and by using its revolving credit facility efficiently. Ares Capital (ARCC), by comparison, has completed an 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.
For this reason, asset managers with higher leverages, 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.
Now let’s look at the earnings expectations of BlackRock, Prospect, and Ares going forward.