What to Consider When Investing in BDCsBrandon Rakszawski, Senior ETF Product ManagerMarch 15, 2021
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10-year U.S. Treasury yields spiked in February, reaching as high as 1.5% near the end of the month. This has caught the attention of income and equity investors alike. With rising yields impacting bond prices, many take a closer look at income alternatives, specifically equity income options that may be less sensitive to increases in rates than traditional fixed income investments. One area of interest is business development companies (BDCs) because of the unique exposure they provide shareholders, paired with their portfolio’s floating rate nature.
A recent article in Barron’s highlighted the opportunity in investing in BDCs. In addition to noting the healthy yields BDCs are delivering—approximately 9%, according to the article—it also provided insights on what investors should keep in mind when evaluating them. In our view, an ETF offers a simple way for investors to access this space.
BDCs provide loans to middle market companies that are too small for traditional bonds and, as such, tend to be difficult for investors to access otherwise. In order for BDCs to get preferential tax treatment, they must distribute at least 90% of their taxable income to shareholders as dividends. Publicly traded BDCs offer investors access to what may otherwise be an illiquid asset class via a liquid, dividend-yielding stock.
Looking Beyond Yield When Investing in BDCs
Earlier this year, NYSE hosted an educational webinar on The Income Potential of BDCs, featuring speakers from Owl Rock Capital, FS/KKR and VanEck. Speakers noted that income and looking to alternative income in the search for yield tends to drive interest in BDCs. Furthermore, BDCs tend to be heavily exposed to floating rate notes, making them well-positioned for rising interest rates.
A challenge investors may face when considering investing in BDCs is that each BDC management team tends to have their own philosophy and will position their portfolios accordingly. Credit risk at the company and industry level may vary. Recent legislation has increased the leverage cap for BDCs from 1:1 to 2:1, so BDCs have more flexibility when managing their leverage targets, which depends on how the BDC approaches capital structure exposure.
Investors seeking exposure to the space but who may not be able to conduct credit research on each individual BDC may consider turning to an ETF. An ETF may also be used to supplement existing exposure to the space. The VanEck Vectors® BDC Income ETF (BIZD) offers access to publicly traded U.S. BDCs, providing diversification across the industry and alleviating the need for individual BDC credit research.
Outlook for BDCs
During the COVID-driven market sell-off in the spring of 2020, BDCs were also hit hard, given that they have more exposure to equity market risk than other income asset classes. However, the leverage cap increase gave BDCs more flexibility to manage through volatile periods, and BDCs have recovered significantly as the U.S. economy reopened and positive vaccine news was announced.
We believe BDCs are well-positioned as the economic recovery continues to take shape. Yield has historically been consistent, and its floating rate exposure may become more of an attractive story line with the potential for further rising interest rates.
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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.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of a Fund carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
Authored byBrandon Rakszawski
Senior ETF Product Manager