This High-Yield Vehicle May Deliver a Bumpy Ride

Question: A friend mentioned business-development companies as an investment idea that pays a good yield. What can you tell me about them?

Answer: Business-development companies, or BDCs, are often compared to private equity funds. That is, they are pools of capital used to invest in various businesses, often small ones in need of funding to help them grow. BDCs typically do this by loaning money to or acquiring equity in these small businesses, which may be privately held or publicly, but thinly traded. One major distinguishing characteristic of BDCs is that they are open to any investor, whereas private equity funds typically are available only to institutional or wealthy investors. BDCs technically are closed-end funds that trade like stocks and often have names that include the words "capital" or "investment." 

One major appeal of BDCs is that they often pay hefty dividends from the high interest rates charged on the loans they make to small businesses. Of course, these high rates of interest reflect the high risk involved with some of these loans, a topic we'll explore in greater detail in a moment. As with REITs, BDCs must pay out 90% of their income each year to avoid paying taxes on that income at the corporate level. (Investors still must pay taxes on the income they receive from the BDC.)

This income-payout requirement, coupled with the high interest rates charged by BDCs for the loans they make, means BDC investors can potentially receive some of the richest yields around. Add in the strong performance of small-company stocks during the current bull market, and it's no wonder interest in BDCs has been on the upswing.

Yields Can Exceed 10%
Two of the largest publicly traded BDCs, Ares Capital (ARCC), with a market cap of $4.9 billion, and Prospect Capital (PSEC), at $3.5 billion, yield about 9% and 13%, respectively. There are more than 40 publicly traded BDCs, and their combined market cap exceeds $30 billion. There are also BDCs that are not publicly traded.

Some mutual funds and exchange-traded funds own BDCs in their portfolios, especially those targeting small- and mid-cap financial-services stocks. There's even a BDC ETF--Market Vectors BDC Income ETF (BIZD), which tracks an index of publicly traded BDCs and which yielded 6.4% on average during the past 12 months. (Morningstar's Mike Rawson discusses how owning BDCs complicates the reporting of mutual fund and ETF expenses here.)

One important difference between BDCs and mutual funds is that BDCs tend to take a more active role in managing the companies they own. For example, a BDC may have a seat on a company's board of directors.

With High Yield Comes High Risk
The sometimes eye-popping yields offered by BDCs has made them attractive investments among income-hungry investors disappointed by today's low rates for Treasuries and many bond types. But that extra yield carries with it significant risks, including the chance that the small companies whose debt the BDC owns will default. Smaller firms can be particularly sensitive to economic downturns, meaning that if the economy heads south, the value of some BDCs, and the nice dividends they pay, could go with it.

Anecdotally, Ares Capital lost 45% in 2008, during the financial crisis, or about 8 points more than the S&P 500. The following year, as the economic recovery began to take hold, it rebounded with a 120% gain. Its five-year annualized gain of 26.3% beats the index by 8 points. However, last year it trailed it by more than 21 points, and so far this year it trails by more than 6 points (figures as of May 9).

Josh Peters, editor of Morningstar DividendInvestor, says he avoids BDCs in part because of a lack of transparency. "I look at BDCs as black-box financing vehicles that pay large dividends because that's the only way they can attract capital for the managers to manage," Peters says. "Outsiders have very little information by which to judge the quality of a BDC's assets, and even a lengthy track record of success can hide all sorts of festering problems. I'm much more comfortable owning large, well-established, moat-protected operating companies directly rather than taking fliers on inherently speculative vehicles like BDCs--no matter how high or seemingly stable their dividends are."

Ratcheting Up the Risk
Compounding the risks of investing in BDCs is the fact that many use leverage, meaning that gains and losses may be larger than they otherwise would be based simply on the performance of the underlying holdings. BDCs are limited to a 1:1 debt/equity ratio, meaning they may not borrow more than their equity is worth. (Some in Congress have proposed raising this limit to 2:1, effectively doubling the amount of leverage allowed to BDCs.)

In its annual list of investment products that warrant increased scrutiny, the Financial Industry Regulatory Authority, or FINRA, last year mentioned BDCs, saying for 2013, "As with other high-yield investments, such as floating-rate/leveraged loan funds, private REITs, and limited partnerships, investors are exposed to significant market, credit, and liquidity risk. In addition, fueled by the availability of low-cost financing, BDCs run the risk of overleveraging their relatively illiquid portfolios."

As part of this year's list, FINRA expressed concern over the practice of BDCs issuing their own debt in small amounts, also called "baby bonds," which individual investors may own. The practice is designed to provide BDCs with greater control over their own borrowing, but FINRA writes, "The secondary market for these instruments is thin, and investors forced to sell prior to maturity may be harmed." 

What Do You See?
BDCs are a wonderful Rorschach test for individual investors. If all you see is the high yield and you can't wait to plunge right in, you're probably making a huge mistake because failing to understand the variety of risks that come with that yield could cost you dearly. If, however, you see an investment that may provide outsized yields but brings with them the potential for high volatility and losses, BCDs may be worth considering.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.