If you're looking for a good primer on business development companies (BDC), Forbes ran an article Oct. 12, 2011 that discusses their background and some of the problems many of these specialized funds faced during the financial downturn. While they certainly have very enticing yields, this income comes with a price. If the economy goes into the tank, a second time, there is little downside protection. Nonetheless, they can play a useful role for any investor looking for income. One of the better-known BDC's is PennantPark Investment (Nasdaq:PNNT), which got its start in January 2007. In October 2010, PennantPark created a second fund, PennantPark Floating Rate Capital Ltd. (Nasdaq:PFLT), which, itself, went public in April 2011. Yielding less from its loans than the original fund, its risk profile is more palatable to conservative investors. I'll explain why you might want to own this niche fund.

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Debt Primer

Before I get into some of the differences between the original PennantPark and its little sister, I'll talk a little bit about the types of debt out there. Essentially there are five main types of debt: revolving, term loan, senior debt, subordinated debt and mezzanine debt. Often, while studying a company's financial statements, you will see the term "bank debt." This refers to its revolving line of credit and term loan, often secured from a commercial bank. These loans are the most senior of the debts, and in the event of a bankruptcy would be the first to be repaid from any funds available. The term of the loans is shorter in nature than any of the other three types, and comes with a floating rate of interest. This is where PFLT invests a majority of its capital. These senior secured loans generally come without call protection, meaning they can be repaid at any time without penalty. When you move into senior notes and beyond, the interest rate charged tends to rise, the duration increases, prepayment all but disappears and generally there is no security. At the back of this pack is mezzanine debt, which often comes with an option to convert the debt into equity. It's here that you experience the term "payment in kind," where interest is added to the balance. (For additional reading, check out: Will Corporate Debt Drag Your Stock Down?)

Differences Between the Two

Now that I've laid out the various levels of debt, I'll explain the differences between the two BDC's. The first difference is their size. PennantPark's portfolio of investments is $779 million as of the end of June, while its little sister had a portfolio of $87.3 million, slightly more than one-tenth its size. The big sister has 47 portfolio companies and an average investment of $16.6 million compared to 28 companies for the little sister and an average investment of $3.1 million.

The type of business each BDC targets, is similar in that they are both seeking companies with annual revenues between $50 million and $1 billion, and whose debt is rated below investment grade. However, the big sister generally seeks higher yielding, higher risk, unsecured investments. In its latest quarter, its portfolio had a weighted average yield of 13.1% with just 38% invested in senior secured loans, which with the exception of revolvers, is the most secure form of debt. It's little sister, on the other hand, finished the quarter with a weighted average yield of 8% with 89% invested in senior secured loans, 9% in second lien secured debt and another 2% in subordinated debt. Its risk profile is definitely much lower. The big difficulty will be finding ways to grow without using too much leverage. (To know more about investment grade debt, read: What Does Investment Grade Mean?)

Another big difference besides the types of debt investments each BDC makes, is the discount to net asset value per share. As of Nov. 9, 2011, the big sister trades at a discount of 8.5% while the little sister's discount is 34.5%. Why such a discrepancy given the risk profile is lower? The big sister has a longer history as a public company, not to mention a larger number of investments. The little sister will gain a track record in time. Intrepid investors can take advantage of this potential mispricing.

The Bottom Line

PennantPark Floating Rate Capital currently pays an annual dividend of 84 cents for a yield of 7.9%. Its big sister pays $1.08 for a yield of 10.1%. If you're looking for income with a little less risk, the little sister is the way to go. If neither of these strikes your fancy, you might want to take a look at PowerShares Senior Loan Portfolio (ARCA:BKLN), which lends to even larger companies, or, alternatively, Market Vectors Investment Grade Floating Rate (ARCA:FLTR), which invests in dollar-denominated floating rate notes issued by corporations with investment grade debt.

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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

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