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Find Yield in a Rising Rate Cycle with BDCs

March 29, 2022

Read Time 4 MIN

The high exposure to floating rate loans in BDC portfolios helps lower duration and reduce interest rate risk, making BDCs well-positioned for a rising rate environment.

Rising rates have been a top concern for investors so far this year. The U.S. Federal Reserve (the “Fed”) has postured for more hawkish policy coming out of a pandemic-era, near-zero rate environment. Many analysts have forecasted that the Fed will implement numerous rate hikes throughout the year that could total over 150 basis points worth of tightening.1 This has left many investors wondering where they can find yield without exposing themselves to excessive interest rate risk ahead of an incoming tidal wave of rate hikes.

Business development companies (BDCs) are one alternative income source investors should consider when looking to enhance yield in their portfolio while still being mindful of rate sensitivity. BDCs offer high income potential with low interest rate risk and may even stand to benefit from a rise in interest rates.

Income Potential of Private Credit

BDCs are similar to closed-end funds and were originally created through legislation in 1980 with the purpose of spurring lending to private companies. BDCs generate income by lending to, and investing in, these companies in a variety of ways including 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.

One defining characteristic of BDCs is their high yield relative to more traditional income assets like corporate or government debt. The private credit nature of BDCs, paired with their tax efficient income pass-through structure and use of leverage, is what allows BDCs to offer these attractive yields.

BDCs Offer Higher Yield Compared to Traditional Income

BDCs Offer Higher Yield Compared to Traditional Income

Source: Source: FactSet. Data as of 2/28/2022. For illustrative purposes only. BDCs is represented by MVIS US Business Development Companies Index; U.S. HY Bonds is represented by ICE BofAML US High Yield Index; REITs is represented by FTSE NAREIT Equity REITs Index; Utilities is represented by Standard & Poor’s 500 Utilities Index; U.S. Stocks is represented by Standard & Poor’s 500 Index; U.S. IG Bonds is represented by Bloomberg Barclays Capital US Aggregate Bond Index; U.S. 10 Yr Treasury is represented by ICE BofAML Current 10-Year US Treasury Index.

When considering an allocation to BDCs, it is important to note that their yield premium over traditional income assets does comes with certain risks that investors should factor into their decision. BDCs are credit sensitive assets, because they lend to small- and mid-sized private companies, and can experience elevated volatility in “risk-off” environments.

The most recent example of this volatility was during the 2020 market turmoil, when BDCs experienced a significant drawdown on fears of the pandemic’s impact on the economy. However, while defaults and non-accrual rates in the BDC market did rise, the increase was not nearly as extreme as many initially feared. BDC valuations and non-accrual rates have since recovered to pre-pandemic levels and the overall credit quality is expected to remain healthy, given strong fundamentals and favorable credit conditions in the space.

BDC Industry Non-Accruals as Percentage of Total Portfolio

BDC Industry Non-Accruals as Percentage of Total Portfolio

Source: Houlihan Lokey, Direct Lending Update November 2021. Reflects cost of nonaccrual investments as a percentage of total portfolio cost for more than 90 BDCs tracked by Advantage Data.

BDCs Are Positioned for Rising Rates

BDCs generate income based on their net interest margins, or the difference between interest income from portfolio investments and interest expense on borrowings/debt. Over 80% of loans, on average, in BDC portfolios feature a floating rate, making BDCs well-positioned to succeed in a rising interest rate environment .2 This high exposure to floating rate loans is a particularly relevant feature of BDC portfolios today as it helps lower duration and reduce interest rate risk.

In fact, many BDCs actually stand to benefit from a rise in base interest rates thanks to these floating rate loans paired with the fixed low rate debt that BDCs have issued over the last year. This means that as base interest rates increase, BDCs may likely see higher net interest margins and increased annual net income. As an example, the below chart shows the projected impact of increases in base interest rates on interest income and expense for Ares Capital Corp., one of the largest publicly traded BDCs.

Ares Capital Corp.: Projected Impact of Increased Interest Rates

Ares Capital Corp.: Projected Impact of Increased Interest Rates

Source: Ares Capital Corp., “Form 10-K: Annual report for year ending December 31, 2021,” U.S. Securities and Exchange Commission, February 9, 2022.

Benefits of a Broad Market Approach to BDC Investing

There are many publicly traded BDCs available in the market today, each with their own risk profiles given their varying exposures in terms of underlying asset structures, sector and credit profiles, financing terms, and even management team experience and capabilities. Allocating to individual BDCs can require significant time and research to properly assess each company and determine a best fit. Taking a broad market approach to investing in BDCs can provide diversification across the industry and alleviate the need for individual BDC research.

The VanEck BDC Income ETF (BIZD) offers broad market exposure to publicly traded U.S. business development companies. BIZD seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the MVIS® US Business Development Companies Index, which tracks the overall performance of publicly traded business development companies. We view this strategy as an attractive option for investors looking to increase income from their portfolios without adding significant interest rate risk.

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Important Disclosures

1 Source: Reuters. Factbox: What global banks forecast for Fed rate hikes in 2022.

2 Sources: BDC financial statements as available on the underlying BDCs comprising the MVIS® US Business Development Companies Index (MVBIZDTG). Data as of 12/31/2021.

Definitions: BDCs: MVIS US Business Development Companies Index is a rules-based index intended to track the overall performance of Business Development Companies (BDC). U.S. Stocks: Standard & Poor’s 500 Index, calculated with dividends reinvested, consists of 500 widely held common stocks covering the industrial, utility, financial and transportation sectors. REITs: FTSE NAREIT Equity REITs Index is a broad-based, free-float adjusted market capitalization weighted index consisting of equity real estate investment trusts. Utilities: Standard & Poor’s 500 Utilities Index comprises those companies included in the S&P 500 that are classified as members of the GICS® utilities sector. U.S. High Yield Bonds: ICE BofAML US High Yield Index (H0A0) tracks the performance of U.S. dollar-denominated below investment grade corporate debt publically issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating. U.S. Investment Grade Bonds: Bloomberg Barclays Capital US Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities, commercial mortgage-backed securities. U.S. 10-Year Treasury Bonds: ICE BofAML Current 10-Year US Treasury Index is a one-security index comprised of the most recently issued 10-year U.S. Treasury bond. To qualify for the inclusion, the 10-year bond must be auctioned on or before the third business day before the last business day of the month.

The S&P 500 Index is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Van Eck Associates Corporation. Copyright © 2021 S&P Dow Jones Indices LLC, a division of S&P Global, Inc., and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of S&P Global and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

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.

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