Are you looking for more yield in a low-yield world? Your answer probably is: Of course, I am. Who isn’t?
If that’s the case, you might consider adding business development companies (BDCs) to your investment portfolio. That’s because the average BDC’s yield of 9.6 percent towers over the average high-yield bond rate of approximately 6.2 percent. Usually, it’s the other way around.
BDCs are publicly traded private equities, made possible by Congress in a 1980 amendment to the Investment Company Act of 1940. BDCs invest primarily in the debt of private companies. Different BDCs specialize in different kinds of debt. But their mainstay has been mezzanine debt (debt that the holders may convert into equity if not repaid) and collateralized loan obligations (pools of leveraged loans). This debt is often issued in connection with private equity buyouts and can be risky.
|BDCs can pay high dividends because of their preferred-tax status.|
The high dividend payments are a result of income tax requirements. Business development companies are required to pay out 90 percent of their income every year to retain their preferred-tax status. The BDC itself does not pay income taxes, but investors pay taxes on the dividends received at their own individual rate.
If you don’t understand BDCs at first glance, you’re not alone. Typical BDC investors are sophisticated and have done their homework.
That’s why the Financial Regulatory Authority placed business development companies on its list of potentially unsuitable investments for 2013. That said, all investing is a matter of weighing risk and return, and in my view BDCs provide a superior risk-return profile to their close competitors: High-yield bonds, master limited partnerships (MLPs) and real estate investment trusts (REITs).
What’s more, BDCs have had an impressive track record through the financial crisis. Oppenheimer & Co. recently reported that BDCs have generated a 59 percent positive return since 2007 compared to other financial intermediaries, which as a group still have a cumulative negative return of about 25 percent depending on which financial services index you use as a benchmark.
However, BDCs take significant credit risks to generate their high yields. Leveraging a portfolio to invest in illiquid-debt securities issued by private companies is bound to be risky. But no BDC went bankrupt during the 2009 financial crisis, although many were forced into workouts with their lenders. And it’s likely that they would come under similar liquidity pressure in the event of another recession.
But for now, their average dividend yield is far more generous than other yield-focused investments. Moreover, this yield level looks to be sustainable even in a modestly rising interest rate environment, because a large portion of the BDC asset base is floating-rate loans.
Coming off a year in which, on average, BDCs registered solid mid-teens total returns, they are well-positioned to generate double-digit returns again in 2014.
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