E Double-Digit Yield Makes Risk Worthwhile

The collapse in the Business Development Company stocks in recent weeks offers an opportunity for investors with many yields in the double-digits, and discounts to Net Asset Value up to 50%.We recommend a basket approach to owning BDCs, owning both more conservative, and lower-yielding, as well as the more distressed with yields in the high teens.The stocks tend to be very volatile since the companies tend to be small and mostly retail-owned, and one should always be alert to opportunities to buy a particular stock at a depressed price.Right now, however, the entire sector is depressed, offering buying opportunities across the board.

Overall sentiment towards Business Development Companies has turned very negative, and most stocks in the sector are down significantly.There is concern about energy companies in the portfolios of many BDCs. Amid general market weakness, there is concern about the impact of higher interest rates, and extreme weakness in the high-yield credit market, with particular concern about the Collateralized Loan Obligation market (many BDCs own CLOs). All this has led to fears of a repeat of 2008-2009, a period that saw many BDCs rack up loan defaults forcing them to slash their dividends.

BDC fears are overblown

These fears are misplaced or greatly exaggerated.In particular, the effect of higher interest rates on Business Development Companies is misunderstood.There are three main ways in which rising rates could affect these companies: by affecting the economy and therefore small businesses; by hurting the rate spread on company’s loans; and by affecting dividend-paying stocks.

The quarter-point hike, and “gradual” outlook for future increases, is not sufficient—in itself—to derail the economy and therefore significantly hurt small business leading to greater defaults.

Most BDC loans are at floating interest rates, for some companies over 90% of loans, meaning that as the level of rates rises, so too will the interest rate due on those loans. This will hold even in a scenario where benchmark rates increase, but many market rates do not.However, most company debt is at fixed rates.Thus the spread could widen in a period of rising rates.

The stocks still sport among the best yields around—partly because the stocks were generally weak last year—and with the ability for dividends to grow over time, higher rates should not be too much competition for the stocks.