BDCs Available At A Discount

BDCs: Good Value After Energy Prices Cratered

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.

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Disclosure: None.

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