By Carla Pasternak
Low Yields in the S&P 500
Venture Capital 2.0
Business Development Companies
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I’ve mentioned before that I often go off the beaten path to find the best income investments in my Street Authority newsletters High-Yield Investing and High-Yield International. These days you have to-remember that the common stocks in the S&P 500 yield only 2% on average.
Luckily, there is an entire world of securities created with income investors in mind. You just have to know where to look.
Case in point: I’ve been tracking a rare breed of company-there are only about three dozen of them on the market. But these rare securities pay hefty yields, with a few exceeding 12%.
These companies are the 21st century version of venture capital funds. You’ve heard of venture capital-it generated a lot of press (and billions of dollars) during the tech bubble. These companies invested in start-ups like Google and Amazon, and made millionaires out of many of their investors.
But the venture capital world has historically been closed to all but the very wealthy. And it certainly hasn’t thrown off high yields for average investors. That’s until this new kind of income investment came to light. Now investors can invest just like venture capitalists-putting money into small companies off-limits to most-while being paid double-digit yields. And they can do it by easily buying and selling shares on the NYSE.
This comes thanks to business development companies-or BDCs for short-which make loans to small companies, often taking an equity stake as well. Most importantly, BDCs pass along the income earned from these investments, allowing them to pay great yields for aggressive investors-many currently yield 8%-11% and a few are yielding 12% or more.
Yields are powered by the high-interest loans BDCs offer the companies they invest in. But yields are also given a boost because BDCs enjoy a tax-advantaged status. They pay nothing in income taxes as long as they distribute at least 90% of taxable income to investors. Dividends are paid at least quarterly and some even pay monthly.
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But business development companies have been around for a while now, so why am I bringing them up?
To complement their high yields, BDCs look to be in a “sweet spot.”
Right now, conventional lenders have tightened up lending, leaving many companies with few options to fund growth. BDCs are one of the few sources of financing available for these businesses; a captive market is good for business.
But as I said above, these yields are for aggressive investors as investing in small companies (especially in a soft economy) can be risky. During the height of the recession, several BDCs were forced to cut distributions to investors.
To offset their investment risk, BDCs don’t invest in just any company-the best BDCs use their expertise to be highly selective. They find undervalued businesses with strong potential and guide their growth by taking seats on their boards and providing consulting advice.
These BDCs also manage risk by holding the bulk of their assets in debt securities. That way, if a company it invests in goes south, the BDC stands a better chance of being paid for its investment compared to an equity stake. BDCs further diversify their risk by owning stakes in many companies at once. The typical BDC spreads the risk across 50 or more different companies and 20 different industries.
With their diversified portfolios (and currently low borrowing rates), I expect select BDCs to continue to be a solid-albeit still volatile-place to earn a strong yield … if the economy can at least tread water.
P.S. I recently selected one particular business development company as my August “High-Yield Security of the Month” in High-Yield Investing. This pick delivers a 12% yield and has gained roughly 30% so far this year. Learn more about this idea here.