While interest rates are set to rise sooner than most predicted, investors should look for a surge from zero to 15% practically overnight. That means investors looking for income will still be reaching for yield and for those looking to score some pretty big dividends, the market may have given you a gift in an esoteric company type.

Many business development companies -or BDCs- are currently traded for discounts to their book values as various funds have sold the firms. That selling wasn’t do to any actual fundamental problem. And given the sector's high yields, now could be a perfect buying opportunity for portfolios still seeking dividends.

Out of Two Major Indexes

The recent selling in BDCs can be attributed to one thing- acquired fund expenses. Business development companies act like publicly traded, mini-private equity firms and as such, they make loans to firms too big for their local bank branch, but too small to launch a corporate bond issue. As middle market lenders, many BDCs will often take equity stakes in the firms and provide managerial assistance in hopes of profiting as these businesses grow.

It’s a profitable place to be and in exchange for various tax benefits, BDCs are required to distribute much of their cash flow back to investors. Unfortunately, it can also be a headache for index and fund providers.

The problem is BDCs are required to report something called acquired fund fees and expenses. While these fees are essentially business expenses- cost of capital etc.- they end up skewing mutual fund and index expense ratios. And in some cases, by a lot. That’s becoming a huge problem as the number of business development companies have surged over the last ten years. Back in 2005, there were just four firms. Today that number sits closer to 30 and the group has over $26 billion in market capitalization.

That increased market cap and size has more BDCs making their way into popular market indexes like the iShares Russell 2000 (NYSE:IWM) and SPDR S&P MidCap 400 (NYSE:MDY). To that end, in order to appease investors who see higher “expense ratios” at the cost of acquired fund fees, index providers S&P and Russell have announced that they will “kick-out” the high yielding securities from their indexes. That’s created plenty of selling pressure over the last few weeks. 

Yet, the growth story for BDCs is still intact. A rising economy is increasing demand for lending, while the IPO and buy-out market remains hot. Both of these factors will continue to see BDCs raising profits and dividends in the months ahead. For investors, the time could be right to snag-up shares as the indexes begin kicking out the firms.

Adding A Dose Of BDC Dividends

Given that selling pressure is not based on real fundamentals and the sector's high yields, investors may want to look at adding some public private equity muscle to a portfolio. A prime way is through the Market Vectors BDC Income ETF (Nasdaq:BIZD).

BIZD tracks 28 different BDCs- including industry titans like Ares Capital (Nasdaq:ARCC) and Prospect Capital (Nasdaq:PSEC), both based in New York. Overall, the ETF offers a broad way to play the sector as well as gain a high dividend yield. BIZD currently spits out a hefty 7.89% distribution. And while at first blush expenses for the fund look high- at 9.34%- the bulk of that is the acquired fees that aren’t actually paid for by investors. Investors can also use the UBS E-TRACS Wells Fargo Business Development Company ETN (Nasdaq:BDCS) to add a wide swath of the sector to their portfolio. 

With biotech and technology being the two hot growth areas, investors may want to focus their BDC efforts in these sectors. To that end, Palo Alto, Calif.-based Hercules Technology Growth Capital (Nasdaq:HTGC) could be the prime pick. HTGC has been immensely successful in identifying the “next-big” things in tech and continues to have many of its portfolio companies IPO. These have included early stakes in Menlo Park, Calif.'s Facebook (NYSE:FB) and San Francisco real-estate firm Trulia (Nasdaq:TRLA). All in all, that’s helped HTGC pay a near 9% dividend. Also providing capital to the high-tech world is Farmington, Conn.-based Horizon Technology Finance (Nasdaq:HRZN). Shares of Horizon currently payout a hefty 11% in dividends. 

Finally, some of the newer and smaller BDCs like Chicago's Golub Capital (Nasdaq:GBDC) and New York's Harvest Capital Credit (Nasdaq:HCAP) could be great buys as they expand their loan portfolios. Meanwhile, investors are treated to larger-than-average sector dividends.

The Bottom Line

The recent selling pressure in the business development company sector has nothing to do with actual fundamentals. For investors looking for high dividends, the recent weakness could be a huge buying opportunity in the BDCs. The previous picks- along with American Capital (Nasdaq:ACAS)- make ideal selections to play the sector and its high yields.

 

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.

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