The FOMC minutes were released yesterday and afterwards Ben Bernanke gave us the benefit of his wisdom. There were, it seems, no great shocks or surprises. QE will continue at the same pace (for now) and short term interest rates will be held close to zero for the foreseeable future. Most of the media attention is on the first part of that statement. The effects of QE and a ballooning Fed balance sheet, and the possibility of it coming to an end, has been the story. For many investors, however, it is the second half of the statement that represents a real, everyday challenge. These are the people who retired with what they assumed was enough money to give them a decent income for the rest of their lives. The problem is, that assumption was based on normal interest rates and a return of around 5-7% from their portfolio. In order to achieve that in the current environment, one must take on a fairly large amount of risk; not something that is easy (or even desirable) when it comes to your life’s savings.
Yield is fundamentally a reward for risk, but risk comes in many forms. In the traditional fixed income investments interest rate risk is the big one. As the search for yield has pushed investors further out the curve (they have invested in bonds that have longer to maturity), their investments have become more sensitive to any future changes in interest rates. When rates rise, and we can be sure they will one day, the value of those holdings will get badly hurt, and the return they are getting will struggle to keep up with inflation. This knowledge has led many to other instruments, such as REITs, high dividend stocks and MLPs. This is where Business Development Companies (BDCs) come in. I should say that BDCs were brought to my attention by Craig Starr of Stifel Nicolaus in New York. Any mistakes are mine, but detailed questions may be better answered by Craig. I have no interest, financial or otherwise in Craig’s practice, but have found him to be a great source of information on his primary field, alternative yield investments.
Like REITs, BDCs are pass through entities, that return all of their profits to investors as dividends and pay no Federal taxes. They typically invest in mezzanine debt; unsecured loans to mid-level, often privately held, companies. The reason I believe they represent diversification for those in need of a return is that many of them have positioned themselves to reduce their exposure to interest rate risk. They have achieved this by investing primarily in floating rate loans, while borrowing at fixed rates. Any future interest rate increase, therefore, will actually benefit them. They have a couple of advantages over other types of investments doing the same thing. They have a 1:1 debt to equity ratio limit, as opposed to 8:1 for banks, and have great transparency as each investment is individually detailed and marked to market in disclosures.
I said that many have positioned themselves for a rising rate environment in the future, and this is true, but not all of them have. For this reason, while there are a couple of ETFs (BDCS, BIZD) available, those looking to diversify away from interest rate risk may be better served by investing in individual companies. Both Hercules Technical Growth Capital (HTGC) and KCap Financial (KCAP) have over 80% of assets in floating rate instruments and 100% of liabilities in fixed rate debt.
HTCG specializes in funding for tech companies, from start up capital to expansion of mature entities, and has a yield of just over 8%. KCAP has a wider spread of sectors that it invests in and offers a yield around 10.5%.
Two stocks with an average yield over 9% and some protection against future interest rate rises sounds too good to be true, right? There has to be a catch. Well, of course, there is. While the structure of these BDCs puts them in a position to be a hedge against future rate rises, what you are doing in effect is swapping one risk for another. These entities have significant credit risk. The loans they are making and investing in are unsecured. Should a company default, the loss on that asset could well be total. For this reason, and the fact that most of their loans are floating rate, both the value of the stock and the dividend paid can fluctuate. Should the economy slip back into recession, then losses would be large. BDCs went into the last recession overly leveraged and many investors got seriously burnt. The risk of similar losses is reduced due to less leverage being employed, but any downturn in the economy would hurt values and dividends.
For the reasons above, these two BDCs are not suitable as investments for all of your hard earned cash. However, assuming that Ben Bernanke is as good as his word and we face an extended period of near zero interest rates, then a 9% yield from a part of your fixed income portfolio is tempting; especially given that they offer some protection should the market decide that the chairman may change his mind.