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Why Closed-End Funds Are Increasing Leverage

Robert Karr

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

(Continued from Prior Part)

Deploying leverage

Closed-end 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 0.74x is thus in line with the average target of 0.65x–0.75x set by its management. But now 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 because interest rates are expected to rise, and the company has a net leverage of 0.47x. The earning power of its investment portfolio and its low leverage puts the company in a strong position for the next few quarters.

Higher returns

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 the 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 in dividends.

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