Business Development ETFs: New Frontier of Income Investing

Business development companies (BDCs) are firms that help small, early-stage companies with financing needs. While BDCs look like venture capital or closed-end investment trusts on the outside, they are actually publicly traded instruments with substantial income potential.

While gaining exposure to small, private companies they otherwise would not have access to, investors have been drawn to BDCs for the yields. Just look at the Market Vectors BDC Income ETF (NYSEArca: BIZD), which debuted in February. BIZD has a 30-day SEC yield of 7.38%. BIZD’s top holdings include Ares Capital (NasdaqGS: ARCC) American Capital (NasdaqGS: ACAS), Prospect Capital (NasdaqGS: PSEC) Apollo Investment (NasdaqGS: AINV) and Triangle Capital (NYSE: TCAP). [Market Vectors Adds Specialized Income ETF]

Ares, American Capital and Prospect Capital combine for a third of BIZD’s weight and Prospect Capital has a dividend yield of 11.6%. Wells Fargo analysts recently had some important observations for investors considering BDCs or an exchange traded product like BIZD.

“We conclude that the characteristics of both REITs and mutual funds have similarities with BDCs. Compared to REITs, BDCs offer strong returns, provide significant current income, and offer liquid access to an otherwise illiquid asset class. However, unlike REITs, the space has seen little representation in market indices, likely due to the relatively small size. We believe that as the space continues to grow in market capitalization, there will be more inclusion. Looking at BDCs relative to mutual funds, we also draw parallels,” according to a note from the bank posted by Brendan Conway of Barron’s.

In addition to REITs, there are parallels between BDCs and another income-generating asset class. BDCs could mirror similar income investments like energy master limited partnerships. MLPs have done well even as interest rates inched higher. Like MLPs, BDCs were designed as a special subset of investment companies. Due to the way they are structured, BDCs act as tax pass-through entities to avoid double-taxation on dividends. [BDC ETF Generates Yield of 7%]

Speaking of rising interest rates, BDCs have structured about 60% of their assets into floating-rate investments, providing some insulation from higher rates. BIZD is up 3.6% in the past 90 days even as Treasury yields trended higher for much of that time.