American Capital has rapidly changed its balance sheet in an effort to split itself into two companies: an asset manager and an asset owner. It sold many of its largest equity investments into a private equity fund it manages, and used its cash to acquire piles of low-yielding, senior floating-rate loans. With an extra helping of leverage, American Capital believes it can generate attractive returns from lower-yielding loans.
The floating-rate loans are central to its spinoff plan, as they are earmarked to be spun off into the BDC when the process is complete.
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As of last quarter, American Capital had $2.3 billion of these low-yielding loans, roughly 31% of its total balance sheet. This quarter, its outsize holdings of syndicated loans could come back to bite. As loan prices trade down, American Capital's book value could take a hit this quarter.
Loan prices dipAccording to data compiled by JPMorgan, leveraged loan spreads excluding energy issues expanded from roughly 4.3% to 4.8% from the end of the second quarter to Sept. 23. Spreads are also widening in junk bonds, leaping from 5% at the end of the second quarter to 6.5%. The spread is the difference between the yield on a loan or bond compared to a risk-free U.S. Treasury security.
As spreads rise, loan prices naturally fall. The average loan in the S&P/LTSA 100 Index traded at $0.92 on the dollar on Sept. 23, 2015, down from $0.95 on July 1.
This could lead to some rather significant mark-to-market losses in American Capital's portfolio when it reports earnings. A three percentage point impairment to its portfolio of senior floating-rate loans would result in about $68 million of mark-to-market losses.Small as it may seem on a total balance sheet of about $8.1 billion, American Capital earned only $67 million in net operating income last quarter, an earnings measure that excludes capital gains and losses.
While in the long run the quarter-to-quarter swings are simply noise, investors shouldn't be surprised if American Capital's bottom-line earnings, and its net asset value, come in a little weaker in the third quarter.
The article Expect a Weaker Earnings Report From American Capital originally appeared on Fool.com.
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