As bond rates continue to plunge, investors are left scrambling for other ways to generate current income in a portfolio. Equity ETFs, and especially those in less mainstream sectors such as REITs and private equity, have become a favorite of many in this environment thanks in large part to nearly double digit yields. Yet as many of these sectors have become more popular, yields have fallen back to earth, causing many investors to look even further off the beaten path for income opportunities. For those who are on this search, there may be a corner that you could have overlooked; firms known as ‘Business Development Companies’ or BDCs.
What is a BDC?
BDCs are a relatively new class of corporation that was created by Congress in order to encourage capital flows to private businesses from publicly traded private equity firms. These firms generally offer companies long-term debt or equity capital to small or middle-market private companies and have even been called ‘the general public’s private equity funds’. Being recognized as this type of firm has certain tax advantages that can be very beneficial to those willing to achieve the listing. Most importantly is the ability to avoid most corporate level taxation, making these firms pass-through entities. In order to achieve this, firms must distribute at least 90% of their ‘investment company taxable income’ to investors and 98% of this figure to avoid all corporate taxes entirely. Thanks to this structure, companies in this segment are often among the highest yielding firms in the equity world, making them favorites of investors who can stomach the volatility inherent in lending to small private businesses (read Three All-Star Leveraged ETFs).
While there are a decent number of options for those seeking individual equities, the space is relatively unpopulated in ETP form for the time being. One pick is the ETRACS Wells Fargo Business Development Company Index ETN (BDCS - ETF report), which follows an index of 26 companies. Top holdings include 10% weightings to Ares Capital (ARCC - Snapshot Report), American Capital (ACAS - Analyst Report) and Apollo Investment Corp (AINV - Snapshot Report) although three more companies comprise at least 5% of assets as well. The main downside to the product is its hefty fee as expenses come in at 85 basis points a year. However, this is more than offset by the fund’s outsized yield which comes in at nearly 7.7% a year.
Yet, for some investors, and especially those looking for greater levels of risk, this may not be enough. For these intrepid asset managers, UBS also offers a leveraged option of the fund, with the ticker (BDCL - ETF report). This product tracks the exact same index as its unleveraged counterpart and actually has the same tracking fee of 85 basis points as well. Despite these similarities, however, there is one big difference; the 2x feature of the fund doubles the yield as well, giving BDCL a current annual leveraged yield of just under 14.6% (note that the yield isn’t exactly double the unleveraged fund due to an assumed financing rate of 0.258%). While this is obviously tough to beat, investors should note that the product is not without its downsides especially in these shaky economic environments (see Top 3 Leveraged ETFs Year To Date).
Since many of the products in this fund are considered financials, they have not been immune from the recent turmoil and have seen prices slump heavily over the past quarter. In fact, BDCS has lost about 18% since inception while the leveraged version, BDCL, has fallen by about 34.6% in comparison. Both products have managed to turn things around in the most recent month—with both posting modest gains—but longer term investors are likely still at a loss. These steep falls have also likely helped to contribute to the impressive yields for the BDC ETNs as the slumping prices make dividend yields go higher in comparison. Should the economy turn around and if investors regain confidence in the space, yields could tumble as stock prices recover. Nevertheless, BDCL looks to remain a king in the yield space for the foreseeable future thanks in large part to the tax structure of the equities in the corresponding index. So for investors seeking to add to current income, but aren’t afraid to deal with significant volatility, BDCL could be a great choice that could also help to diversify portfolios a little more in these uncertain times (see Top Three Leveraged ETFs For A Bear Market).
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