BDCs Offer Income, Rising Rates Protection | ETF Trends

Interest rates are poised to rise, perhaps as soon as March. However, rates are coming off rock-bottom levels, and even as the Federal Reserve lifts borrowing costs, investors will still encounter income challenges.

That is to say that this tightening cycle may not be as punitive to high-yield asset classes as previous hiking regimes were. That could put a spotlight on high-income exchange traded funds, including the VanEck Vectors BDC Income ETF (NYSEArca: BIZD).

BIZD, which follows the MVIS US Business Development Companies Index, sports a 30-day SEC yield of 8.15%. By any metric, that qualifies as a high-yield territory, but BIZD could prove surprisingly durable as rates rise.

“BDCs generate income based on the difference between interest income from portfolio investments and interest expense on borrowings/debt. On average, over 85% of loans in BDC portfolios feature a floating rate, and this heavy exposure to floating rate notes translates to less sensitivity to rate increases,” according to VanEck research.

The floating rate component is just one part of BIZD’s “secret sauce” in rising rate environments. The other is that most business development companies (BDCs) deal with fixed rate loans. Combine rising rates with floating rate notes and fixed rate loans, and it’s possible that as the Fed tightens, BDCs’ net interest income margins could increase.

“We believe these attributes make them an alternative income source that investors should consider to enhance yield without adding significant interest rate risk,” adds VanEck.

Adding to the case for BIZD this year, beyond an obviously tempting income proposition, are the points that BDC asset quality is strong, and these companies have stout asset coverage and ample access to liquidity, if needed. Those are relevant points because, as is the case with other high-yield asset classes, there is some credit risk to consider with BDCs.

“These stocks may be susceptible to equity market volatility and may not be able to replace traditional income exposure, but they may enhance yield depending on an investor’s risk tolerance. As BDCs primarily finance private companies that are historically smaller, middle-market companies, the attractive interest rates associated with these loans comes with the credit risk associated with these companies,” concludes VanEck.

BIZD holds 25 BDCs with a weighted average market capitalization of $4 billion, according to issuer data. Nearly 61% of the ETF’s holdings reside in mid- or small-cap territory.

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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.