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How Closed-End Funds Manage the Risk-Reward Ratio

Robert Karr

No Impending Rate Hike Looks Bullish for Levered Closed-End Funds

(Continued from Prior Part)

Improved yields

Closed-end funds (PEX) have been boosting their yields by deploying capital in marginally risky asset classes or companies. Prospect Capital’s (PSEC) portfolio, for example, generated an annualized yield of 13.3% in fiscal 2Q16 (ended December 31, 2015) across its interest-bearing investments. This represents a 1% increase over fiscal 1Q15 and a 0.3% increase over fiscal 1Q16. The company has also elected to invest in higher-interest-yielding asset classes such as structured credit and online lending. The company is expected to report similar yields in the March and June quarters of 2016.

The Market expects stagnation in yields now that the Fed has decided to keep interest rates unchanged in March 2016. Closed-end funds are thus deploying capital in higher-interest-yielding asset classes such as structured credit in order to generate a higher returns. Prospect’s non-bank structure gives it the flexibility to invest in multiple levels of corporate capital, with a preference for secured and structured lending.

Companies with exposure to real estate and automobiles such as American Capital (ACAS) and United Rentals (URI) have experienced lower yields. Those with higher exposure in the energy sector saw some compression. CIT Group (CIT) saw its yields improve to 6.4%, with average earning assets of $3.9 million.

BlackRock expects improvement

Ares Capital’s (ARCC) weighted average yield on total investments at fair value stood at 9.2% in 4Q15, compared to 9.1% in 4Q14. Its yield has declined over the past few quarters, mainly due to a decline in the yield on subordinated certificates in the SSLP (senior secured loan program) and an increase in low-yielding investments. The company intends to sell these investments to the SDLP (senior direct lending program) on the establishment of a diversified portfolio for the program. However, it also expects to see some recovery in yields in the first quarter of 2016 on improved originations.

By comparison, BlackRock Capital Investment’s (BKCC) weighted average yield stood at 11.0% in 4Q15, compared to 11.6% as of December 31, 2014. Its decline of 30 basis points on a year-over-year basis was expected because the company shifted a composition of its portfolio into slightly lower-yielding senior loans as it monetized equities. The company is expected to see improvement in its yield on investments in high-yielding loans with marginally higher risks.

Continue to the next part for a closer and up-to-date look at originations.

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