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The 30-day SEC yield on the widely observed Bloomberg U.S. Aggregate Bond Index is 4.54%, which is high by historical standards. High interest rates and slumping bond prices will do that. Over the past three years, “the Agg” is down 10.3%.
That decline proves there’s no free lunch in investing and that weakness could be one reason why some clients are looking for more yield while avoiding the disappointment of fixed income strategies previously deemed low to moderate risk. However, advisors know that high-yield assets are usually vulnerable to rising interest rates.
Business development companies (BDCs) certainly qualify as high-yield assets. Take the case of the VanEck BDC Income ETF (NYSEARCA: BIZD). The largest exchange traded funded dedicated to BDCs currently sports a 30-day SEC yield of 10.39%. Undoubtedly, that’s high.
To its credit, BIZD proves that not all high-yield funds incur punishment when rates rise. BIZD, which follows the MVIS US Business Development Companies Index, surged 37.2% for the three years ending April 24.
Inside the Appeal of BDCs
Admittedly, the BDC/bond comparison isn’t germane because BDCs are publicly trading companies, meaning BIZD components are stocks. To its credit, the ETF outperformed both the S&P 500 and the S&P Financial Select Sector Index by wide margins over the past three years.
Some of that out-performance is attributable to the BDC business model. In simple terms, BDCs provide various forms of financing to small and middle market firms that are often avoided or overlooked by traditional lenders – a scenario that gets worse when interest rates tighten. Private credit, including BDCs, can fill that void.
“Unlike banks, which are subject to stricter regulations and capital requirements, private lenders offer more flexibility and can tailor loan structures to meet the specific needs of borrowers,” writes VanEck’s Coulter Regal. “This flexibility, coupled with their increasing pool of capital positions private credit as a crucial source of financing, particularly for businesses that may not meet the stricter criteria of traditional banks.”
One of way of explaining the BDC business model to clients is as follows. The companies that need financing from BDCs aren’t necessarily high credit risks, but they have limited options for procuring capital. As such, BDCs can assign high interest rates to the loans extended to those firms and that’s passed onto investors in the form of high yields.
As a result, BDCs in aggregate sport higher yields than other popular income-generating assets, including high-yield and investment grade corporate bonds, real estate investment trusts (REITs) and Treasurys.
BDCs Could Be Viable Alternative to Private Credit
While BDCs and private credit share similarities, they aren’t identical twins. While advisors may have access to private credit platforms and some clients are apt to want that exposure, it’s not without its drawbacks.
For example, private credit investing often carries minimum investments and stipulations that the investors cannot withdraw funds for several years. Not to mention, private credit is not known for being a liquid asset class. Said another way, it lacks flexibility, but BDCs are flexible.
“BDCs bridge the gap between traditional private credit and publicly traded securities. BDCs offer the same benefits as traditional private credit strategies – the potential for higher yields and diversification away from traditional stocks and bonds – but in a much more liquid form,” concludes Regal.