Inside Those Yield-Rich BDCs

In the hunt for current income, there are few spots with yields as enticing as business development companies (BDCs). This corner of finance consists of some 50 publicly traded firms that loan to private midsize companies. The group has an average yield of about 10% and trades below book value.

“The sector is very cheap, especially relative to the overall market where it’s tough to find value,” says Greg Mason, an analyst at Keefe, Bruyette & Woods. The sector has been battered, but “with a near-10% dividend yield, you don’t need to rip higher to make a very nice return,” he says.

Investing in loans makes sense. Most BDCs hold floating-rate loans while the money they use to buy the loans is fixed-rate. They should do well if rates rise, although there may be short-term pain as investors sell off yield-oriented stocks (already under way). More important, credit of companies BDCs lend to should improve since the Federal Reserve’s reason for hiking rates (which it will get to eventually) is that the economy is improving, says Mason.

BUT THERE IS NO SUGARCOATING that BDCs have had a rough time. Aside from concerns about rising rates, BDCs were punished last year when they were removed from most indexes because of the way they account for expenses, reducing demand for their shares. They also make loans to energy companies and got hit when oil prices crashed in the second half of 2014.

Those tough times have led to a shakeout between BDCs that cover their dividends and have fee structures considered friendly to shareholders, and those that don’t. “There’s been a flight to quality,” says Jason Young, a BDC analyst with alternative asset management firm Resource America. “Now more than ever, you’ve got to find the best-in-breed managers.”

Young’s favorites include Main Street Capital (ticker: MAIN), Golub Capital BDC (GBDC), and Ares Capital (ARCC). They are yielding 6.7%, 7.4%, and 9%, respectively.

Merrill Ross, an analyst with Wunderlich Securities, has Main Street as her top pick. “They are prospering alongside the companies they are investing in,” she says. TPG Specialty Lending (TSLX), and Monroe Capital (MRCC) are long-term holdings good at evaluating credit and lending, says Mitchel Penn, analyst with Janney Montgomery Scott.

Choosing BDCs with the highest yields is the wrong approach, since the biggest dividends go to BDCs that have sold off the most, signaling extra risk.

Prospect Capital (PSEC), Medley Capital (MCC), and Fifth Street Finance (FSC), which yield 13%, 13%, and 11%, respectively, are among the more controversial BDCs. Some analysts are skeptical they can maintain high dividends and say they should trade at discounts to book values. Fifth Street seems to be making shareholder-friendly moves lately, but Ross says, “I’m staying away until they figure out what they want to be when they grow up.”

However, she has a Buy rating on Prospect, which is undertaking a complex spin-out of three divisions into separately traded companies. It is trading at a 76% discount to net asset value. “It’s not for everyone,” she admits. Penn recommends Medley for its recent moves to improve value and thinks it will trade higher. “BDCs can create quite a bit of shareholder value if they’re doing it right,” says Penn. “But the higher yield reflects the risk.”

Other risks to keep in mind: credit. In a downturn, loan defaults could rise. Also, unlike bank-loan mutual funds, which buy the same kinds of loans, BDCs can take on leverage of up to one times their assets. That adds to their returns and risks.

Some BDC execs testified this past Tuesday before the House Committee on Financial Services in support of bills that would allow them to take on more leverage and adjust funding rules. If the bills get traction, it could be a catalyst, says Mason, but he considers it unlikely in 2015


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