Many people have not heard of Business Development Corporations (“BDC”).  Having little insight into these relatively unknown investments means a majority of investors avoid them and buy perceived safer investments such as utilities and large US consumer staple companies – see our last market update on the risk of buying consumer staple companies today www.thorinvestment.com/stable-us-consumer-stocks-investors-beware.  BDCs have been around since 1980, a time when Congress authorized these entities to provide capital to small- and medium-sized private businesses that lacked access to traditional capital resources (banks and public markets).  BDCs have the flexibility to make investments across the entire capital structure of a target company including senior (secured) and subordinated (unsecured) debt, common and preferred stock and convertible securities.  BDCs are regulated like mutual funds but, like REITs, don’t get double taxed as long as they distribute almost all of their net investment income and net realized capital gains annually.

There are four reasons we think BDCs are attractive now:

1. Compelling Valuation – With any security in which we look to invest, valuation is always the place we start. With BDCs, we look at the price/book (P/B) ratio.  Just a few years back, many of the BDCs sold at P/B ratios that were close to 1.5.  Today, we see many publicly traded BDCs selling at P/B ratios under 1.0.  This means that we can buy the BDCs’ assets for less than what the assets are worth.  In addition, you can see from the graph below that yields on BDCs look attractive compared to other investments.
2. Unrecognized – You don’t hear very much news about BDCs because they are not followed by many investors. In addition to being ignored by analysts, BDCs have recently been booted from multiple indexes – this puts price pressure on the asset class.  In February 2014, the S&P eliminated BDCs from their indexes.  Many people thought the Russell indexes would follow suit.  Sure enough, in March of 2014, the Russell indexes removed the BDCs.  The announcement was made in March, with the sales occurring in June.  Given the forced selling and associated price pressure, many BDCs fell dramatically in value (many by 30%+).

3. Competitive Advantage – After the 2008 market crash, the government added layer upon layer of regulations for banks. All the regulations have hindered the banks from lending money without having sufficient asset backing.  Because of this, many well run smaller private companies have struggled to get financing.  This has allowed BDCs to come in and assist these companies without having to compete with the large banks.  BDCs are getting higher yields and better lending terms because of these regulations.

4. Positive exposure to rising interest rates – A majority of the loans made by BDCs are variable interest rate loans. This means that even in a rising interest rate environment, BDCs can generate a profit as loan rates adjust higher.  This is a very different outcome than your traditional bond fund, which will lose value as interest rates rise.

What it means for your portfolio

The key to investing is not only finding value, but also avoiding following the herd (because the herd is often wrong).  For various reasons, many investors are ignoring BDCs and are running to popular investment themes such as dividend paying stocks.  Not only is this segment of the market overvalued but, if interest rates go up, those investors will suffer significantly.  BDCs offer better protection because they generate a significantly higher current yield and their dividends increase as their variable note yields rise with interest rates.  A hidden gem – underfollowed and undervalued!!!