BIZD: Question & AnswerCoulter Regal, CFA, Associate Product ManagerJuly 23, 2021
Investors have sought income opportunities for years as central bank policy has resulted in a prolonged low rate environment. Alternatives to historically low yields on government bonds have been the beneficiary of increased investor demand. Business development companies (BDCs) are one such alternative income source that have seen growing attention. This blog is intended to answer frequently asked questions on BDCs and more specifically, VanEck’s BDC Income ETF (BIZD).
What is BIZD and What are BDCs?
The VanEck Vectors BDC Income ETF (BIZD) is the only ETF to invest exclusively in the equity securities of business development companies (BDCs)1. BIZD seeks to track an index of publicly traded BDCs which are a type of closed-end fund, originally created through legislation in 1980 with the purpose of spurring lending to private companies and thinly traded public companies. BDCs generate income by lending to, and investing in, these businesses using of a variety of sources, such as equity, debt, and hybrid financial instruments. In short, BDCs provide capital to small businesses, and in turn, give investors access to the growth and income potential of private companies that are generally exclusive and difficult to access. For more information on BIZD, visit the product webpage here.
Why are Yields on BDCs High?
One defining characteristic of BDCs is their historically relatively high yield, compared to traditional income assets like Treasury securities or corporate debt. Yields on BDCs historically are high because they make investments in private companies that tend to be rated below investment grade or unrated all together. Because these companies are typically smaller, middle-market companies, the interest rates associated with their loans tend to be higher to account for increased credit risk.
Another factor contributing to high yields for BDCs is because they are treaded as Regulated Investment Companies and aren’t considered taxable entities. In exchange for this favorable tax treatment, a BDC must distribute at least 90% of its taxable income to shareholders as dividends each year. Because of this pass through tax treatment and the private credit nature of BDCs, they have historically provided attractive income potential to their equity investors with yields often near double digits.
Why is BIZD’s Expense Ratio so High?
BDCs, like all publicly traded companies, have operating expenses, such as payroll and real estate expenses. Additionally, many BDCs are externally managed and the external management company will typically charge a management fee, and sometimes incentive fees, to the BDC. Due to an SEC rule addressing funds of funds (such as BIZD), there is a requirement for a fund of funds to report a total expense ratio in its prospectus fee table that accounts for the expense ratios of the underlying funds, including BDCs, in which it invests as an expense item called acquired fund fees and expenses (AFFE).
AFFEs are not accrued daily, nor are they paid directly from the Fund’s net assets. They reflect the Fund’s pro rata share of fees and expenses incurred by investing in acquired funds. AFFEs are reflected in the prices of the acquired funds, and thus are included in the total returns of the Fund. More detail on BIZD’s AFFEs can be found here.
What Kind of Volatility Should be Expected?
Because of the private credit nature of their investments, BDCs can experience periods of elevated volatility, particularly in times of credit stress. BDC stocks are also susceptible to general equity market volatility, as shares of public BDCs are traded on exchanges like stocks of public companies. Other risks related to BDCs that could lead to volatility include leverage risk, issuer risk, and structural and regulatory risk among others. Because of these risks, investors likely should not consider BDCs as a complete replacement to their traditional income exposure. Rather, BDCs should be used to enhance the yield potential of an income portfolio to the degree that matches the investor’s risk tolerance.
BIZD provides one trade access to publicly traded U.S. business development companies, providing diversification across the industry and helping alleviating the need for individual BDC credit research. Three-year risk measures for BIZD, such as standard deviation and beta, as of the most recent month can be found here.
Correlation With Other Asset Classes?
BDCs have historically exhibited a low correlation to traditional asset classes like U.S. stocks, investment grade bonds, and treasury securities. An allocation to this often under-represented alternative may provide the potential for strong, diversified returns, and offer an attractive opportunity for investors seeking new ways to generate income.
How Do BDCs Use Leverage?
In 2018, a legislative change, as part of the Small Business Credit Availability Act, doubled the leverage cap for BDCs from a debt-to-equity ratio of 1:1 to 2:1. This is a notable change for BDCs because they often incorporate the use of leverage as a means to improve yield without increasing the credit risk associated in their investment portfolios. Leverage allows BDCs to be selective with new investments and not be required to stretch for yield by investing in riskier tranches to meet yield targets. The extra leverage has historically been beneficial as it allowed BDCs to rotate their portfolio toward less risky senior investments and away from more subordinated facilities.
However, too much leverage can sometimes mean additional risk, especially during periods of volatility, but because BDCs are treated as Regulated Investment Companies, they must adhere to strict leverage restrictions that when compared to other income-generating businesses, may help protect investors from excessive risk-taking.
1 Source: Morningstar Direct. As of 6/30/2021.
The MVIS US Business Development Companies Index (MVBIZDTG) is a rules-based index intended to track the overall performance of publicly traded business development companies.
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities/financial instruments mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of 3rd party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
An investor cannot invest directly in an index. Returns reflect past performance and do not guarantee future results. Results reflect the reinvestment of dividends and capital gains, if any. Certain indices may take into account withholding taxes. Index returns do not represent Fund returns. The Index does not charge management fees or brokerage expenses, nor does the Index lend securities, and no revenues from securities lending were added to the performance shown.
Business Development Companies (BDC) invest in private companies and thinly traded securities of public companies, including debt instruments of such companies. Generally, little public information exists for private and thinly traded companies and there is a risk that investors may not be able to make fully informed investment decisions. Less mature and smaller private companies involve greater risk than well-established and larger publicly traded companies. Investing in debt involves risk that the issuer may default on its payments or declare bankruptcy and debt may not be rated by a credit rating agency. Many debt investments in which a BDC may invest will not be rated by a credit rating agency and will be below investment grade quality. These investments have predominantly speculative characteristics with respect to an issuer's capacity to make payments of interest and principal. BDCs may not generate income at all times. Additionally, limitations on asset mix and leverage may prohibit the way that BDCs raise capital. The Fund and its affiliates may not own in excess of 25% of a BDC's outstanding voting securities which may limit the Fund's ability to fully replicate its index. An investment in the Fund may be subject to risks which include, among others, investment restrictions, financial sector, small- and medium-capitalization companies, equity securities, market, operational, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount risk and liquidity of fund shares, issuer-specific changes and concentration risks. Small- and medium-capitalization companies may be subject to elevated risks.
MVIS US Business Development Companies Index is the exclusive property of MV Index Solutions GmbH (a wholly owned subsidiary of the Adviser), which has contracted with Solactive AG to maintain and calculate the Index. Solactive AG uses its best efforts to ensure that the Index is calculated correctly. Irrespective of its obligations towards MV Index Solutions GmbH, Solactive AG has no obligation to point out errors in the Index to third parties. The VanEck Vectors BDC Income ETF is not sponsored, endorsed, sold or promoted by MV Index Solutions GmbH and MV Index Solutions GmbH makes no representation regarding the advisability of investing in the Fund.
Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. An investor should consider the investment objective, risks, charges and expenses of the Fund carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 800.826.2333 or visit vaneck.com/etfs. Please read the prospectus and summary prospectus carefully before investing.
Authored byCoulter Regal, CFA
Associate Product Manager