One of the income investment sectors that has grown greatly in popularity since interest rates have plunged in the post-Lehman crisis era is the business development companies (BDCs).
There is plenty of information available concerning them on the Internet, so I'll only hit the points I think are most important here.
In general, the BDCs are an extension and current iteration of a part of the junk bond market popularized by Michael Milken and Drexel Burnham Lambert in the 1980s. That was driven by the fact -- largely overlooked by the financial industry for most of the 20th century -- that the rate of default on non-investment-grade bonds was very similar to that of investment-grade bonds.
The non-investment-grade bonds carried much higher interest rates, though.
Today's BDCs make loans that are similar in structure and risk profile to junk bonds. The loans, however, are not exchange traded and are not liquid the way junk bonds are.
BDCs are very similar to real estate investment trusts (REITs) because they are treated similarly for tax purposes. They both avoid having to pay corporate taxes by distributing all income to their investors annually, and thus operate as pass-throughs.
BDCs also operate very similarly to the way companies like KKR (KKR), Blackstone Group (BX) and The Carlyle Group (CG) operate, except for the income distribution.
They make capital available to small and midsized private and public companies. Those investments can be in the form of debt, equity or a hybrid, but most are in the form of a loan. Those loans are typically either adjustable rate or short to medium term in duration.
That is one of the biggest differences between a BDC and a mortgage REIT. The REITs invest in mortgages that are predominantly long term with fixed rates.
As a result, the prices of REITs are more sensitive to rate changes than are the BDCs because the value of the mortgages held by the REITs are more sensitive to interest rate changes than are the BDCs' loan holdings.
As a result as well, BDC prices will respond more favorably to rising interest rates than do the REITs.
This is very similar to the positive impact rate increases have on the stock prices of banks that have large portions of their carried loans in short- to medium-term loans like credit cards and commercial and industrial loans.
In comparison to REITs, the market capitalization of the majority of the BDCs is small, measured in millions of dollars instead of billions. Because of that, the percentage of institutional ownership of the equity in the BDCs is typically much lower than it is for the REITs.
The lower sensitivity to rate changes combined with the lower institutional ownership also allows for greater equity price stability of the BDCs vs. REITs.
This was spectacularly shown during the 2013 taper tantrum with the mortgage REITs losing a third to half their value while the BDC prices were little changed.
Unlike the REITs, the BDCs are not uniformly similar. There are BDCs that invest across many sectors and others that specialize in specific sectors like technology or real estate.
Because of this, combined with their relatively small sizes and low institutional participation, it's more difficult to get a handle on the status of the business of each BDC. They are not as well followed by analysts as the REITs, and the analysts following them are typically associated with the financial firms providing capital to them.
If you're thinking of investing in the BDCs for income, the safest way of doing so is to either invest in the largest of them or in the ETFs that own several of them.
The largest BDCs are Ares Capital (ARCC), American Capital (ACAS) and Prospect Capital (PSEC).
Ares also just agreed to purchase American Capital, and the combined market capitalization of about $8 billion will make the company similar in size to the REIT Annaly Capital Management (NLY).
Ares, American and Prospect all have diversified investments across several industry sectors.
In 2011, Wells Fargo (WFC) created a tracking index for the BDCs, which was followed by the creation of ETFs for BDCs.
The largest of those, although still very small, is UBS ETRACS 2xLvg Lng WF Busn Dev Co ETN (BDCL), which owns most of the BDCs as determined by the weighting assigned to it by the Wells Fargo Index.
I will be writing about other BDCs soon and in more detail.
