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Time to Avoid Business Development Company ETFs?

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There is now growing concern that the ultra-low yield environment will come to an end soon, as the Fed has hinted at a tapering off of bond purchases, leading many investors to reevaluate yield-centric portfolios. While many investors have focused in on the worrying situation brewing in the real estate market, another high yield space, the BDC world, could also be in trouble.

What are BDCs?

Business Development Companies (BDCs) are firms that lend to small and mid sized (or middle-market) companies at relatively higher rates and often take debt or equity stakes in such companies.

This combination of lending and taking equity stakes is highly beneficial to investors, as BDCs pay out relatively high and stable cash distribution along with capitalizing the equity performance of the borrower. The U.S. law requires BDCs to distribute more than 90% of their annual taxable income to shareholders (read: No Dividend Tax Debate for these High Yield ETFs).

Opportunities or Threats?

Currently, most of the BDCs are expanding their platforms through acquisitions of asset-based lenders as portfolio growth has slowed due to increased prepayment activity in a low interest rate environment.

While the acquisitions add to diversification in the middle-market loan, it would increase BDCs leverage as we move ahead in the year given borrowings at the lender level; though it has declined from 0.56 times to 0.50 times over the past one year.

This is because these investments will be treated as equity investments, which will make the valuation for the firms more volatile from quarter to quarter (read: Top 5 Leveraged Equity ETFs YTD).

This can be explained more in depth with the latest acquisition talks. Fifth Street Finance Corp. announced the acquisition of HealthCare Finance Group (HFG), an asset-based lender to healthcare providers, for approximately $110 million.

HealthCare Finance has an outstanding loan portfolio of 57 loans, worth approximately $270 million, to multiple borrowers on May 6. Hence, the acquisition will increase the leverage of the Fifth Street Finance Corp if the deal is successful. This increased debt burden might hamper its share price performance in the future.

Furthermore, the moves by the Fed have hit BDCs as well, though they haven’t seen the worst of the selling pressure. Should the market crush these BDCs like REITs and MLPs have been recently, we could see a big sell off in this space too.

In this backdrop, we recommend investors to think twice about buying BDC ETFs at present despite the fact these provide outsized yields to investors. Currently, there are three ETFs in the space, each of which is different from the other in some aspects which we have highlighted below (see more in the Zacks ETF Center):

UBS ETRACS Linked to the Wells Fargo Business Development Company Index ETN (BDCS)

Launched in April 2011, this ETN provides investors exposure by tracking Wells Fargo Business Development Company Index. The benchmark is a float adjusted capitalization-weighted Index that is intended to measure the performance of all BDCs.

The note holds 28 firms in its basket with the largest weights goes to American Capital , Ares Capital (ARCC - Free Report) and Apollo Investment (AINV - Free Report) that make up for 10.86%, 9.78% and 9.71% share, respectively. This suggests heavy concentration in top firms and increases the company specific risk.

The product puts a hefty 80% of the assets in small cap securities while mid caps take the remaining portion in the basket. Investors should note that it has amassed only $40.9 million in its asset base and trades in small volume of 32,000 shares per day on average.

This would probably increase the total cost for this fund in the form of wide bid/ask spread. Additionally, the ETN charges a high 85 bps in annual fees from investors.

BDCS returned 7.63% year-to-date and the current annual yield of the index stands at 9.78% (read: 3 Red Hot Dividend ETFs). However, this return may not continue in the future as the securities included the ETN are seeking for more acquisitions of the asset-base lender companies, which will increase their leverage, hurting the performance of the companies.

Market Vectors BDC Income ETF (BIZD)

This is the latest addition to the BDC ETF space making its debut in February this year. The fund seeks to match the price and yield of the Market Vectors US Business Development Companies Index, before fees and expenses. The ETF has $13.5 million in AUM and trades in average daily volume of more than 15,000 shares.

The ETF looks to invest in a variety of BDCs which are traded in the American market. These BDCs generate income by lending to, and investing in, private companies that are generally below investment grade or are not rated, allowing for a high rate of income.

In total, BIZD invests in 26 firms with a relatively high level of concentration in the top names. American Capital and Ares Capital both account for roughly 14% of total assets, while the next three firms combine to account for roughly 18%.

The portfolio is relatively skewed towards pint sized securities, as large caps make up 0% of the fund, while mid caps account for 27% of assets. Dividends are expected to be paid on a quarterly basis and could come in at 7.34% (read: A Closer Look at Market Vectors' New BDC Income ETF).

Investors should note that this is one of the more unique products from an expense ratio perspective. The direct expenses come in at 40 bps a year, and are capped to stay there until Sep 2014. However, ‘acquired fund fees and expenses’ come in at a 7.16%, greatly increasing the gross expense ratio, and resulting in a net expense ratio of 7.56%, though these aren’t borne directly by the fund.  

UBS E-TRACS 2xLeveraged Long Wells Fargo Business Development Company ETN (BDCL)

This is a leveraged ETN and seeks to provide two times (2x or 200%) exposure to the performance of the Wells Fargo Business Development Company Index (the underlying benchmark for BDCS).

The product has attracted $110 million in its asset base and is liquid with trading volumes of roughly 110,000 shares per day. The note is also a winner on the yield front, paying out roughly double the annual yield of its unleveraged counterpart.

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