The name of the game for those Baby boomers retiring en masse continues to be income. As the interest rates continue to hover at historical lows, the search for viable income solutions has taken many portfolios into unfamiliar territory. Convertible bonds, master limited partnerships (MLPs) and real estate investment trusts (REITs) have all become standard equipment for income seekers. Funds like the iShares High Dividend Equity (ARCA:HDV) have exploded in popular and assets. However, while investors have embraced MLPs, REITs and other income solutions, one high yielding sector continues to be ignored. Those seeking big dividends might want to pay attention.
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Public Private Equity
When a giant corporation like GE (NYSE:GE) needs to raise capital, it can go to any investment bank and offer bonds to the investing public. Likewise, when your local neighborhood coffee shop needs to buy a new espresso machine, it can walk into a bank branch and get a loan. But for those companies in the middle-market, finding credit for expansion can be difficult. That's where business development companies (BDC) come in. BDC's invest in or lend to small- to midsized companies and provide managerial assistance in hopes of profiting as these businesses grow. Acting like publicly traded private equity or venture capital, these firms allow retail investors to participate in that process with greater liquidity, more transparency and without the necessary multi-million dollar minimum investments.
Like their REIT and MLP counterparts, BDCs are considered "pass through" investments, and 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. That results in big dividend yields. According to brokerage Stifel Nicolaus (NYSE:SF), only mortgage REITs as sector currently offer a bigger average yield. As of the beginning of March 2012, the average yield for 33 major BDC's was a hefty 9.1%.
Big yields aside, there may be other reasons to consider the sector for a portfolio. As the Great Recession took hold, many BDCs saw their share prices dwindle. The resulting economic recovery saw the sector rebound. As economic data continues to move in the positive direction, BDC's should continue to flourish. Ideally, as the economy improves, the firms that the BDCs lent to will be able to pay back their obligations more easily. Additionally, an expanding economy will result in more demand for credit. Ultimately, both these conditions with benefit BDCs and result in higher dividends for investors.
Adding a Swath
Given the sectors current high yields and improving macroeconomic picture, investors may want to add the sector to a portfolio. The PowerShares Global Listed Private Equity (ARCA:PSP) tracks 66 different global private equity firms including BDCs like American Capital (Nasdaq:ACAS). However, it does include exposure to private equity and buyout firms. So it's a "pure" play on the theme. A better broad play is the UBS E-TRACS Wells Fargo Business Development Company ETN (ARCA:BDCS). The ETN tracks an index of 26 BDC's and yields 9.78%. However, some of the best buys in the sector may be individual firms.
With cleantech, social media and cloud computing giving the technology sector a major rebirth, investors may want to focus their BDC efforts there. The managers at Hercules Technology Growth Capital (Nasdaq:HTGC) have done a good job of identifying the next big things in tech. Previous investments have included biotech's like Amylin (Nasdaq:AMLN) and various internet startups. The latest initial public offering events include solar thermal power plant owner Bright Source Energy. Shares of Hercules yield 8.5%. Also providing capital to the high-tech world is Horizon Technology Finance (Nasdaq:HRZN). Shares of Horizon currently payout a hefty 11% in dividends.
Finally, some BDCs have benefited from relationships with financial titans. Both KKR Financial Holdings (NYSE:KFN) and BlackRock Kelso Capital (Nasdaq:BKCC) are managed by private equity firm Kohlberg Kravis Roberts (NYSE:KKR) and global investment firm BlackRock (NYSE:BLK), and have produced great results. KFN yields 8%, while BKCC pays almost 11.3%.
The Bottom Line
With rates still low, income seekers still need to expand their horizons. Like their pass through cousins, REITS and MLPs, BDCs offer high yields and potential diversification benefits to investors. For those looking for higher dividend yields for their portfolio may want to give the sector a go. The previous picks are great examples of how to do that.
At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.