| Sarasota Herald-Tribune
In searching for yield in a seemingly interminable low-yield environment some investors have stumbled onto a somewhat obscure corner of the securities market called Business Development Companies. While they usually have large distributions, those don’t come without real risk.
BDCs were created by Congress in 1980 to stimulate investment in middle-market U.S. companies. Those are companies that have earnings before interest, taxes depreciation and amortization of about $10 to $50 million. BDC’s are traded on stock exchanges and they can pass through investment income without paying corporate income taxes; the investor pays any required taxes. BDCs are required to invest at least 70% of assets in the non-public debt and equity of U.S. companies and annually distribute at least 90% of their income to stockholders.
BDC’s have not done well even with 2018 legislation that – among several positives – increased the amount of leverage they could use. Using leverage allows them to invest in less risky companies while potentially not impacting their returns. Since that legislation passed an index tracking BDCs has lagged major indices. For example, over the last 1 and 3 years, the total return of the Wilshire BDC index was respectively -6.42% and +5.48%. Over the same periods the Wilshire 5000 was +20.82% and +14.46%
A partial list of risks intrinsic to BDCs: underlying company credit and investment risk; leverage risk as BDCs borrow money to make investments; illiquidity risk as the underlying companies may have no ready market; capital markets risk as BDCs rely on being able to easily borrow money.
As noted, the recent performance of BDCs has not been good. Even if we look a bit longer, 5-year returns were +7.85% versus the Wilshire 5000’s +15.52%.
High dividend yield is a characteristic of BDCs. Over the last 10 years BDCs have generally been one of the highest yielding securities. Historically, BDCs have yielded over 1.5 percentage points more than high-yield bonds (their main competitor) and 7 percentage points more than 10-year U.S. Treasury securities. Recently it wasn’t difficult to find BDC’s with current yields between 7% and 10%.
While future returns are uncertain, an index due to research firm Cliffwater shows BDC’s were recently trading about 5% below their net asset value. This plus their high yields suggests they will provide a higher total return than high yield bonds, whose yields recently were in the 4% range. On the negative side, BDCs have about 2.5 times the volatility of high yield bonds.
Since they invest in illiquid companies, there is the danger that the value that these are estimated to have may differ significantly from their actual value. This could mean that a BDC’s advertised net asset value is misleading.
BDCs offer the same portfolio diversification as high-yield bonds except that they tend to move in the opposite direction to investment-grade bonds while high-yield bonds are more likely to move in the same direction.
The most accurate way to think of an investment in BDCs is as a liquid alternative to an illiquid hedge-fund private equity investment.
All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at email@example.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.