Big Dividends In BDCs

By Aaron Levitt | May 03, 2011 AAA

With the Fed continuing to keep interest rates at record low levels, those seeking income are caught between a rock and a hard place. With the first Baby Boomers making the transition into retirement, this quest of finding reliable sources of income becomes ever more important. Tax-advantaged vehicles such as real estate investment trusts (REITs) and master limited partnerships (MLPs) have become increasingly popular with the retirement set. Funds like the JPMorgan Alerian MLP Index ETN (NYSE:AMJ) and its "pass through" tax nature, have sprouted up in a variety of income portfolios. However, while REITS and MLPs are now common place, another pass through investment vehicle should be on investors watch lists.
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Perfect In The Middle
Small mom and pop businesses can go to their local neighborhood bank and get a loan. Giant multinational corporations can hire an investment bank to sell bonds to the public. But for those companies in the middle-market, finding credit for expansion can be difficult. That's where business development companies (BDC) come in. These firms are publicly traded stocks that invest in private equity and debt. Like their REIT and MLP counterparts, BDCs are not taxed at the corporate level as long as they pay out to shareholders at least 90% of their taxable annual net income each year.

Typically, BDCs will lend capital to small and mid-sized companies at high rates, often taking equity stakes in the companies as well. These lenders will also often take the role of a venture capital firm, by obtaining board seats and helping guide the companies they invest in. In addition, BDCs are required to operate with low leverage, with total debt outstanding not permitted to exceed equity. This equates to a 1:1 maximum leverage. By comparison, most banks have a leverage ratio of more than 10:1 and investment bank leverage typically exceeds 30:1. This combination of debt and equity provides investors a unique opportunity. BDCs have the potential to bestow on portfolios high yields, stable cash distributions and capital appreciation within one security type.

After the drubbing that all stocks took during the Great Recession, the Ladenburg Thalmann BDC index returned nearly 45% in 2010, versus only a 13% gain for the S&P 500. While these sorts of gains probably won't be repeated in 2011, the 8-11% dividend yields that these stocks offer are enticing enough for most income portfolios.

Gaining Access to Public Private Equity
Now may be a good time for investors to consider adding a stake in BDCs to a portfolio. As the economy continues to strengthen, default risk is lowered. In addition, the nearly 157 bank failures in 2010 have created less completion for the BDC sector. For investors looking to add a broad swath of the sector can do so with the PowerShares Listed Private Equity (NYSE:PSP). The fund includes holdings in actually private equity firms like The Blackstone Group (NYSE:BX) and business development companies like Fifth Street Finance (NYSE:FSC). Besides the PowerShares fund, the newly public UBS E-TRACS Wells Fargo Business Development Company ETN (Nasdaq:BDCS) will hone in strictly on the BDC sector. For investors looking for individual BDCs, there are plenty of choices.

Specializing can be a good thing. NGP Capital Resources Company (Nasdaq:NGPC) specializes in investments in the energy sector. The company yields over 7% and allows investors to tap into a variety of private E&P firms and pipeline companies. Hercules Technology Growth Capital (Nasdaq:HTGC) provides capital to the fast growing technology sector. Management has done a good job of identifying the next big things in tech. Previous investments have included Blue Nile (Nasdaq:NILE) and Amylin Pharmaceuticals (Nasdaq:AMLN).

Finally, no discussion about BDCs can be had without the two leaders in the space. Both Ares Capital (Nasdaq:ARCC) and Apollo Investment (Nasdaq:AINV) are two of the strongest in the sector and both yield well over 8%.

Bottom Line
With rates still low, income seekers need to expand their horizons. Like their pass through cousins, REITS and MLPs, business development companies (BDC) offer high yields and potential diversification benefits to investors. As more Baby Boomers begin their retirement journey, the sector should continue to see more demand. The previous BDCs along with Pennant Park (Nasdaq:PNNT) make ideal selections. (For more background on these funds, take a look at Income Funds 101.)

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