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Most of the time, there's a trade-off between
yields and capital gains. Want a stock that could rise
rapidly? You'll have to give up yield. Want a stock that
pays double-digit income? The share price is unlikely to rise too
much.
But I'm spotting a largely unknown corner of the market that
is right now offering the best of both worlds -- strong
yields of 10% or more, combined with rising share prices.
Most investors haven't heard of
business development companies (BDC's). These securities
give ordinary investors the ability to play in a
higher-risk/higher-reward arena usually reserved for large
institutions or wealthy venture capitalists.
You see, BDC's are essentially venture capital firms open to
the public. The companies borrow at long-term rates and loan
money to small companies that can't secure financing from
traditional sources.
The good news for us income investors is that many of these
companies provide strong yields, and their share
prices are soaring. For example, I added one company to my
High-Yield Investing "10%-Plus" Portfolio about
six weeks ago, and already it's ahead over +12%. That's not
unusual; many other BDC's have seen a similar rise.
So what's driving this group of some three-dozen high-yield
companies?
Cheap Government Loans
Like other companies, BDC's can raise capital by selling
shares or securing bank lines of credit. But one source of
funding is unique to BDC's: loans issued by the federal
government's Small Business Administration to BDCs licensed
as Small Business Investment Companies (SBICs).
These loans provide the BDC with secure long-term
financing. Typically, the debentures (or loans) are several
hundred basis points above 10-year Treasury, and today carry
an interest rate of about 6% for the BDC. Depending on the
type of loans they make, they can lend at rates of better
than 14%, pocketing the spread.
With a license, a BDC can borrow up to $150 million, and with
a second license they can borrow an additional $75 million
for a total of $225 million. A bill currently working its
way through Congress would even raise the borrowing limit, providing
additional capital for BDCs.
Fabulous Lending Terms
Besides lending money at exorbitant interest rates to small
businesses that traditional banks won't touch, most BDC's
also offer "mezzanine" financing.
That's an arrangement which allows them to convert their
debt capital to an equity stake in a successful small
business. Or the BDC may be given warrants that allow them
to buy stock at a specified price and time if the indebted
company gains in value. Typically, BDCs also charge a fee
for supplying business advisory services to the companies it
invests in.
This diverse revenue stream give BDC's the ability to
generate high current returns with the potential for robust
future capital gains, a very attractive mix for investors.
BDC's -- Why Now?
But BDC's have always had these advantages. Why are they
seeing interest from investors now?
 First,
while the credit crunch has eased, bank financing remains
tight for small businesses. According to a recent Goldman
Sachs report, "There is a lack of credit availability for
small firms that rely mainly on bank credit." These firms
need to turn to smaller lenders like BDC's for financing.
Then, too, mergers and acquisitions are heating up
worldwide. The increased confidence in the business
community about the value of underlying stock is creating
fertile soil for deal making. As Paul Parker, Head of Global
Mergers and Acquisitions for Barclays Capital, predicts,
"The next two quarters will probably be...a very aggressive
period of speed dating where companies will try out
different combinations to see if they make strategic sense."
BDCs thrive on merger mania, which boosts the capital gains
potential of their existing equity stakes. And as the merger
activity trickles downward to smaller companies, the need
for financing from BDC's for buyouts and acquisitions also
should increase.
And that should lead to higher yields, thanks to the laws
surrounding business development companies.
As Registered Investment Corporations (RIC's), the
businesses must pay out at least 90% of their net investment
income as dividends to shareholders to avoid paying
corporate tax. That's why many of them carry double-digit
yields, and the stronger the earnings, the higher the
yields.
Not All BDC's Are Created Equal
But things weren't always so good for BDC's. The financial
crisis of 2008-2009 wrecked havoc with many of them. Some
were forced to cut their distributions and are slow to
recover.
In searching for the best BDC's of the breed, you need to
look for those with the best loan portfolios that are most
likely to support the distributions entirely out of
investment income. Evaluating the risk/reward profile of a
BDC's portfolio is no easy matter, as credit rating agencies
like Standard & Poor's don't slap a rating on most of the
private companies in their loan portfolio.
But some BDC's do take more risk than others. The key is to
check out whether the loans are senior or subordinated,
secured or non-secured, a first or second lien. Senior
secured debt is the most secure because it's paid back first,
and the lender may seize assets if the loan defaults.
Of course, if a business development company does hold
riskier assets, investors are typically rewarded with higher
yields. In the current improving business environment, this type of BDC's could prove the most lucrative.
Good Investing!
Carla Pasternak's Dividend Opportunities
P.S. -- In my May issue of
High-Yield Investing, I went in search of the
best BDC's to profit from their high-yield bull market. My
results include two top picks -- one yielding 8.3% and one
yielding 11.2%. To learn more about High-Yield Investing
and sign up risk free to read May's issue, please
visit this link.
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