Today, I want to tell you about high-yield BDCs (business development companies). But first, let’s talk about what’s happening in the market…
The S&P is back in bull market territory after rising more than 20% off October lows, largely driven higher by the performance of a select few mega-cap tech stocks. But that pace of rising prices simply couldn’t last. Now, the rally either needs to broaden out to more defensive sectors or it will likely peter out.
High-paying defensive stocks look attractive after a period of underperformance heading into what could be a weaker period for growth stocks in the second half of the year.
But there are still some post-pandemic aberrations lying around in terms of yield. If you know where to look, you can find high yields that don’t often exist in normal environments. The party is still going on for high yields in general and high-yield BDCs in particular.
In fact, huge yields can still be had by investing like the rich.
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As the saying goes, “The rich get richer and the poor get poorer.” This universally known American catchphrase perfectly encapsulates the pervasive attitude regarding class envy and wealth distribution in the American experience. And it does so in just a few words that everyone understands.
The saying is almost exclusively used as an expression of disgust or a cynical objection to the imperfections of society and the fact that the wealthy have advantages that most of us don’t. But the phrase, or the truth behind it, can actually be used constructively. We can learn from the rich.
There are a lot of reasons why it’s easier to make more money if you already have money. But I will just focus on one indisputable fact: The rich have access to opportunities and investments that most of us do not.
Venture capital (VC) is a typical example of such privileged access. Venture capital, or private equity (PE), is money provided to young and growing businesses that otherwise wouldn’t have access to sufficient capital. This money is typically lent at very high rates of interest and/or in exchange for equity stakes (a percentage of ownership). (VC and PE do essentially the same thing except VC focuses primarily on taking equity stakes while PE uses a combination of equity and debt.)
Growing businesses with big ambitions need large amounts of capital in order to expand and grow to the next level. But such enterprises often have difficulty getting sizable enough loans from risk-averse banks, and they are too small to access the capital markets by issuing stocks or bonds. Thus, they are forced into the hands of wealthy individuals and institutions that have money and can dictate very favorable terms.
Along with the expertise to evaluate the most promising companies and their growth prospects, money invested in this way can generate fantastic returns. As a case in point, the global asset management firm The Carlyle Group specializes in private equity and had boasted astounding average annual returns of 30% for decades after its founding.
But this fund catered to wealthy individuals, pension funds and other large institutions by requiring huge minimum investments. Investors included former presidents, CEOs, Saudi princes, and the like. Such outstanding returns could turn a measly $1 million dollar investment into $190 million over 20 years. Unless you’re a Saudi prince or an oil baron like J.R. Ewing you will never have access to this fund or its stellar returns.
But times have changed.
As financial markets have grown in sophistication, venture capital investing is no longer the exclusive domain of the wealthy. There is a little-known class of security trading on the market that enables regular investors to mimic the very same money-making strategies employed by the rich and famous. These companies are known as Business Development Companies (BDCs). And these high-yield BDCs can boost your portfolio returns.
How Business Development Companies Work
A Business Development Company (BDC) is a class of security that trades on the major exchanges in the United States. The securities are the publicly traded stocks of companies that specialize in providing capital to small, upcoming businesses in the initial stages of their development in exchange for high rates of interest and/or equity stakes.
Here are the three things BDCs do when they invest in privately held companies.
- Lend money at high rates of interest.
- Take a percentage of ownership in the form of equity stakes.
- Provide an active consultancy role in the management of a company.
A BDC provides stockholders with the ability to retain the liquidity of a publicly traded stock while sharing in the possible benefits of investing in emerging-growth or expansion-stage privately owned companies.
But BDCs aren’t ordinary stocks. Similar to REITs and MLPs, they are tax-advantaged investments. Because of the economic desirability of fueling business expansion, BDCs are granted special tax status. They pay no taxes at the corporate level provided the company pays out at least 90% of net income in the form of dividends.
High-yield BDCs pay out much higher dividends than ordinary corporations because money normally lost to taxes is available to fuel higher dividend payments. The securities have other peculiarities as well that are primarily designed to limit risk. For example, BDCs cannot invest more than 25% of assets in any one company and cannot borrow more than they have in equity capital (a maximum debt/equity ratio of 1:1).
5 High-Yield BDCs to Consider
Smaller companies tend to benefit most in a booming economy, which could present some risk should growth slow, but most investors are unaware that BDCs exist. And you can still get huge yields. The VanEck Vectors BDC Income ETF (BIZD), which tracks an index of 25 publicly traded BDCs, currently yields 11.4%.
Here’s a list of the five largest BDCs on the market and their current yields.
Ares Capital Corp. (ARCC) 10.31%
FS KKR Capital Corp. (FSK) 13.49%
Owl Rock Capital Corp. (ORCC) 9.60%
Prospect Capital Corp. (PSEC) 11.57%
Golub Capital Corp. (GBDC) 9.81%
If it’s high yields you seek, these five high-yield BDCs are a good place to start. If you want to know what other dividend stocks I’m recommending - both for yield and for growth - you can subscribe to my Cabot Dividend Investor by clicking here.
Do you own any BDCs in your portfolio? Tell us which ones, and how they’ve fared, in the comments below.
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*This post has been updated from a version originally published in 2021.
