The Perfect Income Investment Wednesday, November 20, 2013
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The more I vet income investments, the more convinced I am that business development companies (BDCs) are the investment of choice for many income investors.
BDCs are especially appealing to investors seeking alternatives to traditional fixed-income investments like bonds, certificates of deposits, and savings accounts. Unless you're willing to reach on the risk curve or commit money for several years, most of these investments offer pitiful yields.
But many BDCs, in comparison, pay income that yields 8% to 12%, and do so with sound assurance.
These BDCs make money borrowing at one rate, usually by issuing notes and bonds, and lending at a higher rate. They earn money on the spread, which is not dissimilar to how traditional banks earn money. The differences are that BDCs don't take deposits or offer banking services, and they focus on a specific clientele - small-to-mid-size businesses.
There are a few characteristics, in addition to yield, that make BDCs particularly attractive as fixed-income alternatives.
Liquidity is one. BDCs trade just like ordinary stock. Many individual bonds trade in $1,000 increments, and bid-and-ask spreads can be expansive. They can be difficult for retail investors to buy.
The better BDCs also offer protection against rising interest rates, which can lead to significant capital losses.
When interest rates spiked higher in April, fixed-rate bonds lost money, as did fixed-rate bonds funds. Even a respectable conservative bond fund like the Vanguard Long-Term Bond Fund (NYSE: BLV) experienced double-digit losses.
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In contrast, the High Yield Wealth portfolio owns two quality income BDCs. Both experienced a slight single-digit loss in April, but quickly recovered. I was not surprised. One of these BDCs yields 8.5% and not only regularly raises its payout, it frequently supplements its payout with special dividends.
The other is an income powerhouse. It yields 11.5% and pays its distributions monthly. What's more, every few months, the payout is increased incrementally. It's a terrific low-volatility income investment for those who depend on their investments to meet monthly expenses.
I believe the BDCs we recommend in High Yield Wealth are well-positioned to prosper if interest rates spike again. Over the past year, both have altered their capital structures toward fixed-rate liabilities while their assets remain mostly - 80% to 90% - variable rate. When interest rates rise, the cost of their funds will remain static while income from their loan portfolios will increase.
I actually prefer our BDCs over another asset class that's specifically designed to prosper when rates rise: floating-rate (or variable-rate) funds. These funds invest in low-quality variable-rate bonds and variable-rate bank loans. To goose returns, they employ leverage that itself is variable rate and will rise if interest rates rise.
For example, the LMP Corporate Loan Fund yields 7.2% (which is still less than the yield on our two BDCs). The fund invests primarily in low-rated variable-rate senior bank loans. But it uses considerable leverage - 33% of the fund. When rates rise, so will the cost of borrowing, because the borrowing costs are variable rate.
When income, yield, and interest-rate risk are factored into the equation, a quality BDC is a hard investment to beat from an income investor's perspective.
12 Straight Months of Dividends
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