Bullish on BDCs — Evening Brief – 06.20.24
Regional and community banks are facing significant challenges, including holding large amounts of low-yielding Treasuries that are trading at significant discounts, as well as having excessive exposure to corporate office properties with high vacancy rates. Additionally, the collapse of regional banks in 2023 has led to stricter lending standards.
As a result, companies are increasingly relying on Business Development Companies (BDCs) to fulfill their capital requirements and borrow at current higher interest rates.
The current valuation of the exchange-traded BDC market is $156 billion, which is distributed across 79 BDCs. The typical BDC exhibits a debt-to-equity ratio of 1.1%, indicating minimal utilization of leverage. Like private credit funds, BDCs provide financing to non-publicly traded enterprises, exposing them to limited liquidity. Therefore, the increased return is designed to offset the risk of an unfavorable liquidity event for investors.
BDCs, like REITs, are regulated investment companies (RICs) and must distribute at least 90% of their earned income to shareholders to avoid corporate income taxes. The BDC must meet the requirement of being a domestic corporation and allocate a minimum of 70% of its assets towards investments in private or public U.S. firms that have market values below $250 million.
BDCs in the current market have a significant allocation towards floating-rate loans in their portfolios, which means that these loans will increase in value if short-term interest rates climb.
The Federal Reserve’s 11 interest rate increases have greatly increased the profitability of the BDC industry. The most successful portfolios are now invested at least 90% in debt issues that have variable interest rates related to either the federal funds rate or the Secured Overnight Financing Rate (SOFR). Today, SOFR stood at 5.31%. The loans provided by BDCs will be structured with a rate of SOFR plus 6%, resulting in a total interest cost of over 11% for the borrower.
When BDCs invest mostly in private illiquid businesses, it is often the case that their lending rates exceed 13%. Consequently, investors are currently benefiting from attractive dividend yields that vary from 8% to 14%.
An effective strategy to mitigate the risk associated with investing in BDCs may be to explore the option of investing in an exchange-traded fund like the Van Eck BDC Income ETF (BIZD), which holds a portfolio of the biggest BDCs based on their assets under management. The 30-day SEC yield for BIZD is 10.03% and pays a quarterly dividend.
Given the limited availability of loans from banks, the increasing need for funding from private companies, and the Federal Reserve’s stricter monetary policy that seems likely to continue at current elevated levels, conditions for BDCs look optimistic.