Generous Yields & Large Capital Gains? It's as Easy as BDC!

05/02/2017 2:46 am EST

Focus: FINANCIALS

Mike Larson

Editor, High Yield Investing

Business Development Companies receive generous yields on investments and loans, pay out handsome dividends, and are doing well in today’s market, according to Weiss Ratings senior analyst Mike Larson. He shares his Top 10 list.

Extremely juicy, market-beating dividend yields. Large capital gains on top of that. Attractive leverage to an improving economy. Relative immunity to the rate-hiking cycle...or even enhanced profit potential because of it?

It sounds too good to be true. But finding all of that is as easy as “BDC.”

The acronym stands for Business Development Company, a type of specialty finance company that toils away in relative obscurity but that’s doing very well in today’s market. Specifically, these lender/asset manager hybrids help finance smaller, development-stage and higher-risk companies by investing in their debt and equity securities. Those companies either can’t or don’t want to turn to traditional banks, or need the hands-on advice and mentorship that BDCs provide.

The underlying companies that BDCs fund are clearly riskier than your standard blue-chip, mega-corporations. But BDCs receive generous yields on their investments and loans as a result. They then turn around and use the hefty yields they receive to pay out handsome dividends to shareholders.

In fact, BDCs have to distribute at least 90% of their taxable income as dividends–much like Real Estate Investment Trusts (REITs). But unlike REITs, which tend to underperform when interest rates rise, BDCs can actually benefit from Federal Reserve interest rate hikes.

That’s because many of their loans are of the floating rate variety, and are pegged to the key, global benchmark interest rate called the London Interbank Offered Rate (or LIBOR). LIBOR rises in virtual lockstep with the federal funds rate the Fed controls. So as the Fed hikes rates, the interest rates BDCs receive on their loans climb. That boosts their interest income–and if all goes well, the dividends they can pay out!

I recently compiled a “Top 10” list of leading BDCs at the Weiss Ratings website, using our stock screening tools. You can see that the dividend yields these stocks pay out are extremely generous–an average of 8.1%. That’s more than quadruple the 1.9% yield of the SPDR S&P 500 ETF (SPY).

Those BDCs also produced a 1-year total return of around 34% on average–roughly double the return of the SPY during the same time period. Plus, they all merited grades of “B-” (BUY) or better from our Weiss Ratings stock model.

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Source: Weissratings.com, Data Date 5/2/2017

Of course, BDCs do have risk. The companies they lend to may not be able to pay them back. General underperformance by the financial sector can hold them back. Some BDCs also have very targeted portfolios, meaning if the industry they focus on runs into trouble, they could see losses surge.

But it’s clear from stock charts of the top BDCs–including Gladstone Investment Corp. (GAIN), Golub Capital BDC Inc. (GBDC), and Main Street Capital Corp. (MAIN)–that investors are comfortable with those risks, and confident that the generous dividends are sustainable.

So, if you’re looking to juice your income, and maybe grab some hefty capital gains as well, give BDCs like these a try.

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