2014 Outlook On Business Development Company ETFs

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The need for passive income from dividend yields is higher than ever with throngs of baby boomers retiring every day. At a time when inflation erodes gains from paltry interest paid on savings accounts, investors have warmed up to alternative sources of income, such as business development companies, some of which offer double-digit yields.

Three exchange traded products track the space: E tracs 2X Leveraged Long Wells Fargo Business Development Company Index ETN ( BDCL ), Etracs Linked to theWells Fargo Business Development Company Index ETN ( BDCS ) andMarket Vectors BDC Income ( BIZD ).

Grier Eliasek, president ofProspect Capital ( PSEC ), a business development company in New York City, explains the ins and outs of his industry and his outlook for the year.

IBD: What are business development companies, or BDCs?

Eliasek: Business development companies (BDCs) are publicly traded, high-dividend-paying firms that primarily focus on lending money on a senior, secured basis to private, middle-market companies, which are companies that typically have revenues less than $500 million. Senior secured loans are senior in a company's capital structure to all other outstanding debt and are paid first. They're similar to private-equity investments without having to meet the high-income or net-worth requirements.

The BDC industry has existed for decades with an established track record of strong yields and total returns to investors. BDCs are an undiscovered asset class for investors, similar to REITs two decades ago and MLPs a decade ago.

There are 42 publicly traded BDCs with a combined market value of more than $30 billion vs. about $5 billion five years ago, representing average annualized growth in excess of 40%.

Over the past five years, the BDC index has delivered a 213% total return compared to 138% for investment-grade bonds, 135% for high-yield bonds, 128% for the S&P 500 index, 117% for equity REITs, 96% for leveraged loans and 75% for the S&P 500 Financial index.

BDCs as a group have also outperformed the S&P 500 on a current yield and total return basis since the first publicly traded BDC completed its initial public offering in 1960. BDCs have delivered this performance with low correlation with other fixed-income asset classes, showing that adding BDCs to an investor portfolio can enhance performance while reducing volatility.

BDCs deliver attractive yields to investors, with BDC dividend yields ranging from 7% to 13% vs. 1%-20% for master limited partnerships (or MLPs), 4%-5% for leveraged loans, 3%-4% for investment-grade bonds, 3%-4% for utilities, 1.5%-3% for five- to 10-year Treasuries and 1%-2% for S&P 500 stocks.

IBD: How are BDCs structured compared with regular corporations? Why do they pay out dividends?

Eliasek: BDCs are like banks where they lend money to companies; however, BDCs are not structured like banks. As long as BDCs pay out at least 90% of income to investors in the form of dividends, BDCs avoid corporate taxation, which makes BDCs tax-efficient stocks for investors to own.

BDCs have access to the equity and debt capital markets and are structured like closed-end funds. But BDCs over time have tended to trade at a premium relative to their net asset value, or NAV, due to the high dividends paid by BDCs.

BDCs use independent firms to calculate the market value of their portfolios each quarter, thereby providing greater investor transparency than most other public companies.

IBD: How reliable are BDC dividends?

Eliasek: BDCs as a group today cover their dividends out of income. Most BDCs reduced dividends during the last recession and then increased their dividends as the economy recovered.

No BDC has ever gone bankrupt or failed to repay its indebtedness. Losses on BDC assets have averaged only 0.5% per year, compared to 2.5% for banks. Today many BDCs have near-zero default rates in their portfolios due to a growing economy.

BDCs by law must maintain low debt levels. Their total debt outstanding cannot exceed total equity, substantially reducing investor risk. By contrast, banks can borrow 10 times their equity. Many BDCs can also borrow money from banks and issue debt to institutional and retail clients.

IBD: What are the investing prospects for BDCs this year?

Eliasek: Most BDCs currently trade near book value, while most financial services companies trade at two to three times book value.

BDCs tend to lend at floating interest rates while borrowing money at fixed interest rates. So their earnings would increase if floating Libor interest rates were to increase significantly. Bonds yielding fixed rates are expected to suffer losses as interest rates go up (bond prices and rates move opposite each other).

More stringent bank regulation also favors BDCs in the current environment. New rules limit banks from making loans unless more than 50% of the debt can be repaid within five to seven years. That significantly restricts how much money banks can lend to private middle-market companies. BDCs have stepped into this lending vacuum.

IBD: What challenges do you see your industry facing this year?

Eliasek: BDCs can invest in private middle-market companies in a variety of ways. BDCs can lend money to companies owned by private-equity companies. They can lend money to companies owned by founders and management teams. They can also buy companies.

Approximately 90% of BDCs focus solely on providing capital to companies owned by private-equity companies. As more capital has entered the BDC market, returns on investments have started to decrease and company leverage has started to increase in private equity sponsor-owned companies, making other investment strategies relatively more attractive.

IBD: What are the risks of investing in this sector?

Eliasek: Most of the 42 publicly traded BDCs have small balance sheets with limited capability to serve as the sole lender for many private companies. Smaller BDCs also lack access to the investment-grade debt markets, which results in less diversified sources of funding when the next recession occurs.

Investors focused on larger BDCs can enjoy greater diversity, greater access to capital markets, larger teams and greater trading liquidity.

Business Development Company ETPs And Current Yields

1. Etracs 2X Leveraged Long Wells Fargo Business Development Company Index ETN ( BDCL ): 14.7%

2. Etracs Linked to theWells Fargo Business Development Company Index ETN ( BDCS ): 7.16%

3.Market Vectors BDC Income ( BIZD ): 5.6%



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: BDCL , BDCS , BIZD , PSEC

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