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Finding Big Yields in BDCs

For dividend hunters, companies that are set up as “pass-through” entities can be great places to find extra yield. In exchange for various tax benefits, these firms will often send much of their cash flows back to investors as dividends. As a result, investors are able to score yields well in excess of market norms. And when it comes to pass-through entities, real estate investment trusts (REITs) and master limited partnerships (MLPs) are two perennial portfolio favorites.

But investors may want to add another, often ignored pass-through style security to their income lists.

In this case, we’re talking about business development companies (BDCs).

Offering high yields and a chance to participate in a market that is normally reserved for high net-worth individuals or institutional investors, BDCs could be an income seeker’s best friend.

Public Private Equity

Like MLPs and REITs, BDCs’ history starts with Congress trying to spur investment in an underutilized industry/sector in America. An amendment to the Investment Company Act of 1940 gave private citizens the ability to invest in private debt. That, in turn, gave them the ability to invest in privately held companies.

Today, BDCs have evolved and can be thought of as “public private equity” or venture capital firms.

Many midsized firms are too small to launch a full corporate bond issue with an investment bank and are too large to go their local bank branch and request a loan. That’s where business development companies come in. BDCs invest in or lend capital to small or midsized companies and provide managerial assistance in hopes of profiting as these businesses grow. These loans are often at above market rates and, in many cases, the BDC will also receive equity in the firm. That can be particularly advantageous if the midsized firm has an exit event, such as a sale or IPO.

Where retail investors benefit is that BDCs allow for portfolios to participate in that process with greater liquidity, more transparency and without the necessary multi-million dollar minimum investments. They also provide for greater dividends.

Like REITs, BDCs must distribute at least 90% of their taxable income to shareholders every year as dividends. And because of their loans’ high interest rates and their ability to add some leverage to their books, business development companies offer outsized payouts. On average, BDCs will yield between 7% and 15%. And no, that wasn’t a typo.

A Few Risks

Now, that high of a yield, especially yielding around 15%, comes with some risks.

For starters, BDCs can be negatively affected by rising interest rates in a few ways. As a high yielding security, typically share prices for BDCs will fall as investors find “safer” alternatives that yield higher amounts. Secondly, as their own borrowing costs rise, the shrinking spread between loans and that cost can reduce their cash flows. Finally, some of the loans that BDCs originate are considered floating rate loans. Borrowers can run into trouble when rates rise and they now have to payback more money.

It can also be kind of difficult to gauge the credit and investment quality of the underlying companies in the BDC’s loan portfolio. After all, there are multiple ratings agencies that cover bonds from General Electric (GE ). Not so much for a small mom-n-pop producer of plastic goods. This can result in investors taking on more risk than they realize.

Making a BDC Play

Despite the risks, investors may want to get to know BDCs. They can offer a powerful boost to a dividend portfolio. However, like most risky investments, they aren’t something to bet the entire farm on. With that in mind, the VanEck Vectors BDC Income ETF (BIZD) could be a great starting point.

BIZD tracks 26 of the largest business development companies in the United States. That gives investors exposure to basically the entire industry. From sector stalwarts and safer BDCs to those making riskier loan types, the diversification allows for less single stock blow ups. Even with tracking so many firms, the ETF still pays a very healthy 9.45%.

For investors going the individual route, several BDCs have profited from being backed by some serious private equity muscle. Blackrock Capital Investment Corp (BKCC ), Ares Capital (ARCC ) and Apollo Investment Liquid error: internal have all benefited from their relationships with some of the biggest private equity investors on the planet. They also feature dividend yields in excess of the index.

Additionally, there have been plenty of smaller BDCs launched since the end of the credit crisis to fill the need for more capital. BDCs like Main Street Capital Corporation (MAIN ), Monroe Capital Corporation (MRCC ) and Golub Capital BDC (GBDC ) feature smaller portfolios of loans. So instead of having diversification as their risk prevention tool, they all focus on better underwriting.

The Bottom Line

For investors looking for high income, business development companies (BDCs) deserve to be on your list. There are some risks with them, but the rewards – and dividend yields – can be great as well.