Get Yields Up to 15% with BDC Investments

Business Development Companies Provide a Hedge Against Market Uncertainty with Uncommonly High Yields

Street with Arrows

When the market is looking uncertain, investing in business development companies may be an avenue worth thinking about.

Business development companies (a.k.a. BDCs) are similar to venture capital funds, except that they are publicly traded on stock exchanges so that anyone—not just millionaires—can invest in them. They provide financing to small- and mid-size companies that are often underserved by banks and other traditional lenders. Often this financing includes “mezzanine loans” that pay high interest rates and come with or can be converted into equity in the target company.

Two main things you need to know about investing in BDCs:

  1. BDCs typically borrow funds at much lower interest rates than those paid by the smaller companies, so investors reap the rewards of the spread—although it does make these investments fairly interest rate-sensitive (which could come into play if the Fed cuts interest rates again soon).
  2. Business development companies can have very high yields—frequently in the double digits—but those payouts often reflect the high risk of lending to speculative, development-stage companies. BDCs that make loans primarily to more mature businesses with positive cash flows will be safer, while BDCs that make more speculative loans to smaller businesses will be riskier—but they may also have more growth potential, especially if they take equity positions in a lot of their portfolio companies.

How to Find Out if a BDC is Risky or Safe

Looking at a business development company’s filings should give you a sense of how risky or safe their loan portfolio is. Some BDCs mostly make higher quality loans that have a better chance of getting paid back, while others will make more speculative loans that have higher interest rates but also carry a greater chance of default. You can check the interest rates on the loans for a sense of the borrower’s creditworthiness. If the BDC is able to charge higher interest rates than its peers, it’s probably making riskier investments.

BDCs also have to take on a lot of debt themselves, so they can then lend that capital at higher rates. Luckily for you, that means bankers have already looked at this company’s balance sheet and assessed its financial health, so you can take a shortcut by looking at what kind of interest rates the business development company is paying on its own debt. That will give you a general idea of how risky bankers think this company is.

Also, find out if the rates are fixed at that level or if they’re a floating rate, which can expose the business development company to more interest-rate risk. You may also want to compare the BDC’s debt-to-equity ratio to the industry average to see if this BDC has more or less financial flexibility than its peers. Some BDCs may even be rated by one of the big ratings agencies.

Tax Advantages to BDCs

One other bonus: when you invest in business development companies, there can be tax advantages. Some BDCs pay distributions that are taxed at ordinary income tax rates, but others consistently designate a portion of their distributions as Return of Capital, which aren’t taxed until you sell your shares.

Some BDCs may also designate some of their distributions as qualified dividends, which are taxed at a lower 15% dividend tax rate. How the distributions are treated depends on how the BDC earned the income. Interest the BDC earned from loans and preferred stock is taxed at your normal income tax rate, for example, while qualified dividend income from preferred stock will be taxed at the 15% rate.

Tax benefits aside, business development companies are an often overlooked method of income investing—and a great place to find high yields, sometimes as high as 15%. In the current market climate, high yields can be a nice buffer against frequent share-price fluctuations.

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