U.S. Markets open in 7 hrs 33 mins

How Closed-Ended Funds Are Taking Advantage of Low Interest Rates

Robert Karr

High Expectations for Closed-Ended Funds, but What's Driving Them?

(Continued from Prior Part)

Deploying leverage

Closed-ended funds have taken advantage of ultra-low interest rates inside and outside the United States in order to earn spreads by deploying capital in asset classes that yield higher returns. Ares Capital’s (ARCC) net DE (debt-to-equity) ratio of 0.69x is thus in line with an average target of 0.65x–0.75x set by management. The company is focusing on lowering its cost of debt and maintaining a prudent maturity level for its debt and diverse sources of capital.

BlackRock Capital Investment (BKCC), by comparison, commands a premium in valuations mainly due to lower leverage. The Market sees this as safe since interest rates are expected to rise, and the company has a net leverage of 0.45x. The earning power of its investment portfolio and its low leverage puts the company in a strong position for the next few quarters.

Prospect Capital is highly leveraged

Prospect Capital (PSEC) continues to make use of leverage to generate higher returns. The company’s fiscal 2Q16 (ended December 31, 2015) net debt-to-equity ratio rose marginally to 77.9% from its fiscal 4Q15 debt-to-equity ratio of 77.6% and its fiscal 4Q13 debt-to-equity ratio of 55.7%.

Prospect Capital still has significant unencumbered assets, matched book funding, access to diversified funding markets, and an unsecured fixed-rate liability focus. The company is looking at spin-offs and at increasing leverage as sources for raising capital. More leverage should allow Prospect Capital to generate a higher return for its equity holders.

Reducing cost of debt

Closed-ended funds (PEX) are replacing their existing debt in order to reduce the effective rate of interest. Prospect Capital’s cost of debt is approximately 5.6%, compared to the more than 6% it saw in the prior year. It achieved this reduction by repaying certain higher-cost debts and by using its revolving credit facility efficiently.

TPG Specialty Lending (TSLX), American Capital (ACAS), and United Rentals (URI) are also working on reducing their cost of debt in order to improve their net margins.

Continue to the next part for a look at who’s paying the most dividends.

Continue to Next Part

Browse this series on Market Realist: