With many considering various ways to diversify their an income-generating portfolio in a changing market environment, investors may look to business development companies and related exchange traded funds as an alternative to traditional fixed-income assets and to enhance yields without piling on interest rate risk.
“At the same time that rising interest rates are weighing on income investors, the desire for yield persists,” Meredith Larson, Product Manager of ETFs at VanEck, said in a note. “However, investors have options without the meaningful interest rate duration found with traditional fixed income investments, and BDCs are one of those options.”
For example, the VanEck Vectors BDC Income ETF (NYSEArca: BIZD) tries to track the performance of the MVIS US Business Development Companies Index, which is comprised of publicly traded BDCs.
BDCs may offer a competitive risk-to-return tradeoff, compared to high-yield bonds, leveraged loans and equities across the market capitalization spectrum, Larson said. Additionally, they come with attractive yields, historically averaging about 8.7%. BIZD currently shows a 12-month yield of 8.12%. However, potential investors should keep in mind that these high yield levels are an indicator of potential credit risk.
Business development companies generate attractive yields since they are required to pay out 90% of income in the form of dividends. This is a structure similar to what income investors find with real estate investment trusts, or REITs.
BDCs are comprised of companies that fund small- to mid-sized private companies, which are usually rated below investment grade or not rated at all – these companies would find it harder to acquire traditional means of loans, so they turn to outside sources of capital. Since the financial crisis, regulators have clamped down on traditional lenders, making it harder for many businesses to access public capital.
Consequently, many of these private smaller businesses turned to loans from BDCs as an alternative. BDCs act as an alternative to bank loan debt, helping smaller companies grow and profiting off the investments, which in turn would then help investors gain exposure to the growth and income potential of these privately held companies. In an expanding economic environment, BDCs should also benefit from stronger domestic businesses.
Moreover, BDCs should also do relatively well in the kind of environment ahead where many expect an increase in interest rates. Since BDC loans are mostly floating rate, the companies could earn more as rates rise.
“A particularly pertinent feature of BDC portfolios today is that, on average, more than 70% of the loans made by BDCs include a floating rate feature,” Larson said. “These loans, in general, reset interest payments based on three-month LIBOR interest rate floors of 1%-1.25%. With three-month LIBOR currently over 1.1%, many BDCs’ loan portfolios may now benefit from the floating rate feature by adjusting their yields upwards should interest rates further increase.”
Investors who are looking for a high-yield, equity income position may consider BDC exposure to complement a traditional income-oriented portfolio.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.