What to Consider When Investing in BDCs

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10-year U.S. Treasury yields spiked in February, reaching as high as 1.5% near the end of the month. This has caught the attention of income and equity investors alike. With rising yields impacting bond prices, many take a closer look at income alternatives, specifically equity income options that may be less sensitive to increases in rates than traditional fixed income investments. One area of interest is business development companies (BDCs) because of the unique exposure they provide shareholders, paired with their portfolio’s floating rate nature.

A recent article in Barron’s highlighted the opportunity in investing in BDCs. In addition to noting the healthy yields BDCs are delivering—approximately 9%, according to the article—it also provided insights on what investors should keep in mind when evaluating them. In our view, an ETF offers a simple way for investors to access this space.

BDCs provide loans to middle market companies that are too small for traditional bonds and, as such, tend to be difficult for investors to access otherwise. In order for BDCs to get preferential tax treatment, they must distribute at least 90% of their taxable income to shareholders as dividends. Publicly traded BDCs offer investors access to what may otherwise be an illiquid asset class via a liquid, dividend-yielding stock.

Looking Beyond Yield When Investing in BDCs

Earlier this year, NYSE hosted an educational webinar on The Income Potential of BDCs, featuring speakers from Owl Rock Capital, FS/KKR and VanEck. Speakers noted that income and looking to alternative income in the search for yield tends to drive interest in BDCs. Furthermore, BDCs tend to be heavily exposed to floating rate notes, making them well-positioned for rising interest rates.

A challenge investors may face when considering investing in BDCs is that each BDC management team tends to have their own philosophy and will position their portfolios accordingly. Credit risk at the company and industry level may vary. Recent legislation has increased the leverage cap for BDCs from 1:1 to 2:1, so BDCs have more flexibility when managing their leverage targets, which depends on how the BDC approaches capital structure exposure.

Investors seeking exposure to the space but who may not be able to conduct credit research on each individual BDC may consider turning to an ETF. An ETF may also be used to supplement existing exposure to the space. The VanEck Vectors^® BDC Income ETF (BIZD) offers access to publicly traded U.S. BDCs, providing diversification across the industry and alleviating the need for individual BDC credit research.

Outlook for BDCs

During the COVID-driven market sell-off in the spring of 2020, BDCs were also hit hard, given that they have more exposure to equity market risk than other income asset classes. However, the leverage cap increase gave BDCs more flexibility to manage through volatile periods, and BDCs have recovered significantly as the U.S. economy reopened and positive vaccine news was announced.

We believe BDCs are well-positioned as the economic recovery continues to take shape. Yield has historically been consistent, and its floating rate exposure may become more of an attractive story line with the potential for further rising interest rates.