Income investors scouting for really juicy yields are often attracted to business development companies (BDCs).

These REIT- like vehicles lend to small- and medium-sized businesses, often on a junior or “mezzanine” basis with warrants attached. They then pass the returns through as dividends without paying corporate tax.

Now, these vehicles have suffered a rough couple of years – but many are now selling at discounts to net asset value (NAV), making them attractive value investments.

Buying BDCs on the Cheap

BDCs fill a useful gap in the U.S. financing system by providing loans of medium - and long-term maturities to companies that would otherwise have difficulty raising such capital. After all, we live in an era when banks have become notably unaggressive in lending to small- and medium-sized businesses.

The interest income that BDCs receive provides a steady revenue stream from which expenses and dividends can be paid. Meanwhile, the warrants that are often attached to the loans provide capital gains, which make the shares more interesting.

Additionally, BDCs are only modestly vulnerable to a rise in interest rates, since their lending rates are generally much higher than Treasury bond yields. However, they’re highly vulnerable to recession or downturns that expose credit vulnerabilities, such as the recent downturn in the energy sector.

Currently, the operating performance of BDCs outside the energy sector is favorable, with earnings mostly covering generous dividends and asset values trending upwards. BDC Reporter, run by the hedge fund Southland Corporation, gives helpful advice on the sector as a whole.

In the last year, BDC prices have declined because the energy price decline exposed their vulnerabilities. This has led many BDCs to trade below their net asset value. Frankly, I don’t know why you’d ever buy a BDC above net asset value. Such a premium allows the management to flood the market with new shares, meaning your premium doesn’t last. On top of that, attractive warrant realizations generally don’t make asset values rise much.

Indeed, one set of BDCs you should avoid are those that frequently issue new shares below net asset value. Prospect Capital Corp.(PSEC), for example, has issued more than 75 million shares below NAV since 2009. Its net asset value per share has correspondingly declined from over $14 to $10.31, removing most of the benefit of its high dividend.

But if shares are trading below net asset value and you think the managers are capable and the portfolio is decent quality, then BDCs represent a good bet. That said, BDCs do require some analysis before buying.

Which BDC Is for Me?

Some BDCs that I like at present prices are as follows:

1. Fifth Street Finance Corp. (FSC) is one of the largest BDCs, with $4.3 billion-worth of assets under management. It specializes in debt investments, although it may invest in equity alongside the debt. FSC’s investments span a range of industries, though it’s not invested in the energy sector. 

FSC pays somewhat irregular dividends, currently at the rate of $0.06 per month, for a yield of 11%. The dividend isn’t covered by earnings on a trailing four quarters basis, although it was covered in the first and second quarters of 2015. FSC is trading at 71% of net asset value and eight times projected 2016 earnings.

2. Solar Capital Ltd. (SLRC) has a portfolio of $1.17 billion, with senior secured assets comprising 90% of asset value. It makes loans in a broad range of industries including energy. However, in spite of the name, it doesn’t specialize in solar power financing. 

SLRC pays a $0.40 quarterly dividend for a yield of 9.5%. As with FSC, the dividend isn’t entirely covered by trailing four quarters earnings, but it will be well covered by projected 2016 earnings. SLRC is trading at a historical P/E of 15 times and at 75% of net asset value.

3. THL Credit, Inc. (TCRD) is a smaller BDC ($360-million market capitalization) that has just received an additional follow-on investment from BlackRock. TCRD invests both debt and equity in middle market companies. 

At June 30, 48% of its portfolio was first lien debt, 23% second lien debt, 15% subordinated debt, and 15% other assets and equity securities. TCRD currently trades at 8.2 times P/E, with the trailing four quarters’ net income just covering its $0.34 quarterly dividend. Finally, it yields 12.3% and is trading at a discount of 15% to net asset value.

Bottom line: BDCs shouldn’t represent too large a percentage of an income investor’s portfolio. They’re just too vulnerable to recession and erosion of net asset value. However, for a modest investment that will spice up the portfolio’s overall yield, they can be a good choice.

Good investing,

Martin Hutchinson