Position For Rising Rates with BDCs as Credit Concerns Abate
July 12, 2021
Read Time 3 MIN
In the current low, and potentially soon to be rising, interest rate environment, Business Development Companies (BDCs) are an alternative income source investors should consider, when looking to enhance yield in their portfolios, without adding significant interest rate risk.
Credit Concerns In the Rear-View
BDCs generate income by lending to, and investing in, private companies that tend to be rated below investment grade or unrated, and are generally difficult to access. This private credit nature of BDCs, paired with their pass through tax treatment, has historically provided high income potential to their equity investors with yields often near double digits. However, these same investments in less mature and smaller private companies, can also lead to credit concerns in “risk-off” environments, as seen during the pandemic last year.
BDCs were hit hard during the first half of 2020 on credit concerns surrounding the pandemic and lockdowns however, they have since seen a significant recovery as the U.S. economy has reopened and economic data has been strong. In fact, BDC valuations, as represented by the MVIS® U.S. Business Development Companies Index (MVBIZDTG), have completely recovered to pre-pandemic levels. Additionally, and perhaps even more importantly, the portion of non-accrual status loans, or loans with overdue interest payments, in BDC portfolios have been falling over the last few quarters. The below chart shows falling non-accrual rates for some of the largest publicly traded business development companies.
BDC Non-Accruals at Cost
Source: BDC Quarterly Investor Presentations. As of 6/30/2021, Ares Capital Corp. (ARCC), Main Street Capital Corp. (MAIN) and Golub Capital Bdc (GBDC) were holdings in the VanEck Vectors BDC Income ETF, constituting 15.5%, 5.0% and 4.5% of the fund’s net assets respectively.
BDCs Are Positioned for Rising Rates
Despite the current low rate environment, potential rate hikes are on the minds of investors and interest rate fears are beginning to creep back into the market again as the U.S. Federal Reserve (the Fed) is no longer just “talking about” raising rates. Recent Fed comments signaled the potential for higher interest rates earlier than expected and rates on 10 Year U.S. Treasuries have already risen by almost 100 basis points since the lows of last year.
BDCs generate income based on their net interest margins, or the difference between interest income from portfolio investments and interest expense on borrowings/debt, and are well positioned to succeed in a rising interest rate environment with over 80% of loans, on average, in BDC portfolios featuring a floating rate.1 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 issued over the last year. This means that as base interest rates increase, BDCs will likely see higher net interest margins and increased annual net income. As an example, the below table shows the projected impact of increases in base interest rates on interest income and expense for Ares Capital Corp., one of the largest publically traded BDCs.
Ares Capital Corporation Projected Impact of Base Rate Changes in Interest Rates
|Change in Base Interest Rates||Interest Income||Interest Expense||Annual Net Income|
|Up 100 Basis Points||$25M||$15M||$10M|
|Up 200 Basis Points||$146M||$30M||$116M|
|Up 300 Basis Points||$261M||$46M||$215M|
Source: “Form 10-Q,” U.S. Securities and Exchange Commission, April 28, 2021.
As such, BDCs may serve as a complement to income allocations to help enhance yield without adding significant interest rate risk and may even benefit from rising rates. Investors can gain exposure to BDCs through the VanEck Vectors® BDC Income ETF (BIZD) which provides one trade access to publicly traded U.S. business development companies, providing diversification across the industry and alleviating the need for individual BDC credit research.
1 Sources: BDC financial statements as available on the BDCs comprising the MVIS® US Business Development Companies Index (MVBIZDTG). Data as of 3/31/2021.
The MVIS US Business Development Companies Index (MVBIZDTG) is a rules-based index intended to track the overall performance of publicly traded business development companies.
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 MarketVector Indexes 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 MarketVector Indexes 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 MarketVector Indexes GmbH and MarketVector Indexes 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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