Dividend Yields Hiding in Plain Sight

I tackled the weird and wonderful world of business development companies, or BDCs, in last weekend's Barron's. The instruments resemble a fixed-income fund in an equity wrapper, that offer annual dividend yields approaching 10%. 

That compares with the 5.5% an investor would earn on a widely followed index of high-yield bonds, or the S&P 500's 1.4% yield. And there's protection from rising interest rates as the Federal Reserve begins to tighten monetary policy—many BDCs will see their incomes rise as rates do.

I wrote: 

BDCs are a public play on private credit. Created by Congress in 1980 to spur investment in small and midsize private businesses, BDCs raise capital from investors to purchase portfolios of debt and equity in companies generally valued at less than $250 million. Like real estate investment trusts, BDCs distribute at least 90% of their income to shareholders and don’t pay corporate income taxes.

They have no shortage of targets. A flood of capital into private-equity funds has meant more leveraged buyouts to finance, just as traditional banks have shied away from riskier lending in the post-global-financial-crisis era.

Loans extended by BDCs tend to have floating interest rates, meaning that interest income should rise as benchmark rates go up. On the other side, BDCs tend to borrow at fixed rates, holding their costs steady.

There are of course downsides to BDCs—7% or higher dividend yields don't come without tradeoffs. For starters, backers collect high fees, which raise the bar for returns. And investors essentially need to bet on a management team's track record, with the illiquid holdings of each BDC challenging to independently scrutinize.

Diversification is the way to go. That means holding multiple BDCs, but also seeking out managers with different industry focuses and strategies. 

We highlighted several BDCs in last weekend's feature, plus an exchange-traded fund that offers an easy way to track the industry.

Read about those here.