Updated Sept. 11, 2023 4:30 pm ET
Competitive yields are tough to find in the stock market these days. For investors who aren’t averse to risk, business development companies offer an exception.
BDCs typically raise money from public stock investors that they then lend to small, often private, companies. After banks pulled back from lending in the wake of the 2008-09 financial crisis and again in March following the collapse of a handful of midsize lenders, BDCs helped fill the void.
They give individual investors the opportunity to tap into high-yielding private markets that are usually only open to big, sophisticated institutions. The companies pay out at least 90% of the interest they receive in cash dividends, much like real-estate investment trusts, adding to their popularity among small investors.
Double-digit dividend yields are the industry norm. , for example, sports a forward dividend yield of 11.8%, based on its most recent declared payout. and offer 11.3% and 10.8%, respectively.
The 10-year U.S. Treasury—generally considered by investors to be free of default risk—yields 4.29%. Ultrasafe money-market funds yield about 5.16%, according to Crane Data, while exchange-traded funds that focus on speculative-grade lending typically used to fund corporate buyouts yield about 8.6%.
The fat yields on BDCs come with a catch: Unlike a standard fixed-pay bond, the payouts aren’t set in stone. What the shareholder actually receives depends on what the BDC earns from its investments. BDCs could end up paying dividends that are smaller—or larger—than projected. They are also typically taxed at a higher rate than most dividends paid out by corporations.
Among the risks? BDCs typically don’t fare well in recessionary periods. Their earnings take a hit in the event any portfolio company defaults on a loan. That makes avoiding credit losses a priority for managers.
“We avoid any sector of the economy that is in secular decline, or is cyclical or too volatile,” said John Kline, president and chief executive of New Mountain Finance. He said his fund will typically research a new sector for anywhere between six months to two years before considering an investment.
BDCs ran into trouble at the onset of the Covid-19 pandemic when businesses that borrowed from them struggled to recover after the lockdowns. They pulled back from making new loans to focus on supporting their existing investments that were at risk of default. Shares of some of the biggest BDCs lost almost half their value in the first quarter of 2020. The U.S. government offered temporary relief to make it easier for the companies to continue lending during that period.
“As BDCs have become larger, we can now offer financing to much larger and more important companies than before,” said Craig Packer, CEO of
Corp. “Today, we lend to companies that any lender would like to finance.”
Blue Owl lends to nearly 200 companies for a total portfolio of nearly $13 billion.
BDCs can close on a loan more quickly than a bank, several industry executives said. As a result, companies are often willing to pay a higher interest rate as compensation for the increased speed and higher likelihood of closing a deal.
“We can turn around a private credit in four to six weeks,” said Matt Stewart, chief operating officer of Oaktree Specialty Lending. “That has value for issuers.”
Rising interest rates have been a boon to the sector. About 80% of BDC assets are floating rate loans, according to Robert Dodd, senior analyst at Raymond James. That means the companies earn extra income from their loans when rates go up, as long as their borrowers can make their payments.
“The best scenario for the sector is rates that are high enough, but not so high that they cause economic stress,” he said.
The S&P BDC Index, which includes 39 publicly traded companies, has gained 18.1%, including dividends, this year through last week, slightly outperforming the S&P 500, which has advanced 17.5% on the same basis.
Companies in the BDC index have an average market value of about $1.4 billion, and the largest,
Corp, has a market cap of nearly $11 billion.
Shares of BDCs aren’t found in many common investment products. Securities and Exchange Commission rules require any mutual fund or index fund that owns BDCs to report management fees earned by the company as a fund expense. That drives up expense ratios reported by funds and, in turn, limits interest from institutions in the sector.
Longtime investors in the space say the extra income from BDCs is worth it, as long as the risks are fully understood.
“If we are going to have a recession, these stocks are going to be down,” said Randy Rochman of Glencoe, Ill., a retired investment professional who owns stock in several BDCs, including Oaktree. “If people are wrong, and you don’t have a deep recession or a recession at all, these things make a lot of sense to own.”