BIZD: Question & Answer

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?
• Why are Yields on BDCs High?
• Why is BIZD’s Expense Ratio so High?
• What Kind of Volatility Should be Expected?
• Correlation With Other Asset Classes?
• How Do BDCs Use Leverage?

How can investors buy VanEck ETFs?

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. 

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 treated 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. 

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.