BDCs: An Overlooked but High-Paying Income Investment

Investors are being drawn to high-yielding alternative investments that diversify portfolios, but there’s one paying relatively substantial income that most individuals probably don’t know about: business development companies (BDCs).

BDCs are financial companies that make capital loans to small, private companies, including startups and established firms getting back on their feet after a decline.

Many BDCs are private firms, and investing in them may involve substantial fees. Yet for public BDCs, whose shares are traded on major stock exchanges, fees aren’t really an issue for purchasers because dividends are after fees.

Some public BDCs are currently paying shareholders dividend yields of about 10%. This relatively high yield is enabled by federal rules that give BDCs an excise tax exemption if they pay out 98% of their net income to investors as dividends.

Many companies borrowing from BDCs don’t have good credit ratings but are deemed acceptable risks by BDC management teams. Default rates on loans have been quite low in recent years.

Though BDCs have been around since 1980 — when Congress passed legislation enabling them in order to give small, private companies broader access to capital — many individual investors aren’t aware they exist; investment comes overwhelmingly from institutions.

This is a small investment universe. There are about 50 publicly traded BDCs, with about $130 billion in aggregate assets. Only four BDC exchange-traded funds (ETFs) are now listed on U.S. exchanges.

Pros and Cons

Advantages of public BDCs for investors include:

· High investment income. Their yields are higher than most income investments, including high-yield (aka junk) bonds. Increasingly popular among individual investors in recent years, high-yield bond funds are now paying about 7% annually — about 50% less than some BDCs.

· Recent growth. Though BDCs are purchased primarily for income, share prices of some of the larger ones have risen more than 10% in the past 12 months.

· Diminishing economic risk. Generally, the biggest risk of this investment is recession. As of last fall, many economists saw a near-term recession in the cards for this year. But because of the continued strength of the economy, this outlook has disappeared from many radar screens.

· Industry diversification. Owning BDC shares affords indirect exposure to a wide array of industries among borrowing companies.

· Augmented expertise. The legislation that spawned these companies requires them to make management guidance available to borrowing firms, increasing their chances of success and repaying loans. Sometimes, BDCs acquire a vested interest in the form of a small ownership stake.

Disadvantages include:

· Credit risk. Companies that borrow from BDCs tend to have credit ratings below investment grade, meaning a comparable credit rating on debt for these lenders. Potential investors should learn the credit rating on a BDC’s debt (if available) to assure that it isn’t too low for comfort. If they’re comparing BDCs to lower-paying, high-yield (aka junk) bonds, which by definition have below-investment grade credit, investors should keep in mind that these bonds’ default rates are generally about the same as BDC borrowers.

· Lack of transparency. Credit ratings on debt aren’t available on many of the smaller public BDCs. This data is more commonly available for large BDCs, but for competitive reasons, even some of the larger companies may be a bit opaque. Though focusing on performance records may make this opacity moot for some investors, others may find it off-putting.

· The potential for investors to over-react to volatility. Though BDCs can diversify portfolios, they are nevertheless common stocks. So their share prices may decline below their fundamental value — the value of the loans they hold — from changes in investor sentiment or market liquidity. Warren Buffett has famously said that volatility isn’t the same as risk, but fear of it can prompt investors to sell prematurely, when investments are down.

The allure of public BDCs has increased significantly in the last couple of
years from yields elevated by sustained high-prevailing interest rates resulting from rate increases by the Federal Reserve Board (the Fed) to counter inflation.

Another growth driver: Demand among BDCs’ borrowers for alternative financing sources has increased since several regional banks failed last year, causing federal regulatory pressure to ratchet up, making it more difficult for small companies with less-than-stellar credit to get bank loans.

Lingering Onus

Many individual investors believe that public BDCs carry more risk than they actually do. Apparently, an onus from this misconception is still lingering from decades ago, when these companies lacked a track record.

Institutional investors have no such confusion. Aware of BDC performance and low default rates, they’ve piled into BDCs this year to provide clients strong investment income.

Like these institutional buyers, individuals should base buying decisions on their level of confidence in the management team, as reflected by performance. As management acumen can vary significantly, there’s usually a wide gap between the top- and bottom-performing tiers of BDCs.

The interest on BDC loans is usually from a variable, floating rate, so it will inevitably decline along with prevailing rates, paring dividend yields.

Currently, the Fed is widely expected to begin a series of interest rate cuts by fall. But, as these cuts would likely be in small increments, BDC yields probably wouldn’t decline significantly for a while.

Regardless, declining rates ultimately tamp down the yield of all income investments, not just BDCs. Investing in them is about seeking high yield at the time relative to other options.

What to Look For

In evaluating BDCs, investors should look for the larger public players, with market caps of more than $1 billion; a credit rating on debt of at least Baa3; a high projected return relative to analysts’ price targets; and a market price not much higher than the total value of the company’s loans.

Here are four BDCs that meet these criteria:

· Ares Capital Corporation (NASDAQ:ARCC): Market cap: $12.80 billion. Annual dividend yield: 9.16%.

· Owl Rock Capital Corp (NYSE:OBDC): Market cap: $6.04 billion. Annual dividend yield: 10.97%.

· Golub Capital BDC Inc (NASDAQ:GBDC): Market cap: $4.07 billion. Annual dividend yield: 10.1%.

· Barings BDC (NYSE:BBDC): Market cap: $1.07 billion. Annual dividend yield: 10.26%.

As with individual stocks, investors seeking ETFs in this space should go big. Far and away, the two largest are:VanEck BDC Income ETF (NYSE:BIZD), with $1.2 billion in assets, and Putnam BDC Income ETF (NYSE:PBDC), with $91.7 million.

Overall, public BDCs can be a good way to boost investment income with manageable risk. For most individuals, portfolio allocations probably shouldn’t exceed 10%.

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Dave Sheaff Gilreath, CFP, is a partner and chief investment officer at Sheaff Brock Investment Advisors and Innovative Portfolios®, Sheaff Brock’s institutional Arm. Tom Kaiser, CFA®, CPA®, a portfolio manager with the firms, contributed more than equally to this article. Based in Indianapolis, the firms managed assets of about $1.4 billion as of June 30, 2024.

The investments mentioned in this article may be held by those firms, Innovative Portfolios’ ETFs, their affiliates or related persons.