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    BDCs Responding Favorably to Recent Fiscal Policy

    VanEck
    June 07, 2018
     

    Recent legislation has been serving as a tailwind for business development companies (BDCs). The passage of this year’s omnibus spending bill, which included the Small Business Credit Availability Act (SBCAA),1 as well as last year’s tax reform were expected to positively impact BDCs. In fact, since the spending bill’s March 22 announcement, the MVIS US Business Development Companies Index was up 6.9%, outperforming the main U.S. equity and other high yield indices.2

    Analysts covering the space have generally expected the tax plan to be a modest net positive for BDCs, in part due to the lower tax rate combined with its limits on the deductibility of interest expense.

    Meanwhile, one of the main implications for BDCs from the SBCAA is the leverage limit increase from 1:1 to 2:1.The new limit is modest compared to the much higher leverage, on average, of banks or mortgage REITs. For example, this increased leverage flexibility would allow BDCs to invest conservatively with relatively stronger risk-adjusted return potential, subject to shareholder or board approval. This could reduce the need for lower grade investments to help enhance yield potential. However, how much of, and to what extent, the BDC universe will employ this new flexibility remains to be seen.

    The Current Case for BDCs

    BDCs currently average about 9.3%3 in dividend yield and over 80% in loan portfolios with floating rate loans, which may allow BDCs to benefit from a rising interest rate environment.4 As such, BDCs may serve as a complement to income allocations to help enhance yield without adding significant interest rate risk. In addition, BDCs have historically offered a competitive risk/return tradeoff when compared with high yield bonds, leveraged loans, and equities across the market capitalization spectrum.

    Annualized Standard Deviation versus Annualized Return (%)
    8/4/2011 – 5/31/2018

    Chart showing annualized standard deviation (risk) versus annualized return

    Source: FactSet, Bloomberg. Data as of May 31, 2018. Past performance is no guarantee of future performance. Index performance is not indicative of fund performance. Indices are not securities in which investments can be made. See index descriptions and additional disclosures below.

    Allocating to BDCs can help investors gain exposure to the growth and income potential of privately held companies, which has traditionally been limited to institutional or high net worth investors. BDCs lend to and invest in small- to mid-sized private companies, which tend to be either rated below investment grade or not rated at all. Therefore, investors should have a risk tolerance for securities rated below investment grade (i.e., high yield/BB+ or below). Furthermore, publicly listed BDCs are equities and may be sensitive to investor sentiment and subject to greater volatility than high yield bonds or leveraged loan portfolios.

    Along with historically attractive income and growth potential, given their access to the private middle market space and high relative yields, BDCs also have a high level of floating rate loan exposure. Combined with the recent tax reform and passage of the SBCAA, we believe the current case for BDCs is compelling. High yield and equity income investors may want to consider a diversified allocation of BDCs to complement their traditional income portfolios.

    Investors can gain exposure to BDCs through VanEck Vectors® BDC Income ETF (BIZD®).