COLUMN-Business Development Companies: High yield, high risk

Fri May 17, 2013 7:59am EDT

By John Wasik

CHICAGO May 17 (Reuters) - In a frantic search for yields, investors often turn toward relatively unknown products. Business Development Companies (BDCs) are one of latest vehicles to grab investor attention - and money.

BDCs are companies that lend to young, thinly traded and often distressed companies that have credit ratings in the "junk" status. They are as close to a private equity enterprise as you're going to get in a public company. Yet their high yields come at a price in terms of elevated risk that should not be underestimated, and investors must proceed with caution.

Like Real Estate Investment Trusts (REITs), BDCs must pass through at least 90 percent of their profit to shareholders. Most of their borrowers carry the lowest-possible credit ratings such as BBB-, or are not rated at all. They hold a variety of companies in their portfolios, so some are more diversified than others.

As high-yield vehicles, BDCs have been emerging at a relatively rapid clip in recent years. There were just four of them nine years ago. Now, there are nearly 30, with a total market capitalization of $26 billion, according to Financial Advisor, a trade magazine. That's peanuts compared with megabanks like JPM Morgan Chase & Co or Bank of America Corp, but they are a growing force in corporate finance.

While regulated, BDCs occupy a useful niche in helping companies grow. Since they can borrow at record-low rates and make money on the spread - the above-market rates they charge less credit-worthy borrowers - BDCs are in a sweet spot now as the economy continues to rebound. They can provide financing to a wide range of companies typically eschewed by mainstream banks. Consider them sub-prime lenders to small- to mid-size companies.

If you're going to hold BDCs at all, it's best to own a diversified portfolio of them through an exchange-traded fund or note. There are currently two products on the market that hold BDCs. Both of them are new, so there is not much of a track record to evaluate.

The UBS ETRACS Wells Fargo Business Development Company Exchange-traded note tracks an index of BDCs and pays a 6.7 percent yield. It has gained 6 percent year-to-date and returned nearly 30 percent over the past year through May 15. Holdings include 28 BDCs such as Ares Capital Corp, which specializes in financing private middle-market companies, and Prospect Capital Corp, which provides debt and equity capital to the same market.

The Market Vectors BDC Income ETF offers a 7.6 percent yield, but has been on the market only since February. It holds 26 companies including American Capital Ltd and Fifth Street Finance Corp and has returned 3 percent over the past three months through May 15.

WARNINGS

Be careful with these vehicles as regulators and certified financial planners have raised concerns. Earlier this year, FINRA, the securities industry self-regulator, singled out BDCs for their "significant market, credit and liquidity risks." The availability of low-cost financing means BDCs "run the risk of overleveraging their relatively illiquid portfolios," FINRA noted.

Not all of the BDCs are publicly traded. The nontraded variety, sold through brokers who take commissions up to 7 percent, pose even higher risks because there may be no viable secondary market for them. Both nontraded and traded BDCs are highly volatile.

"If you don't like the volatility of publicly traded BDCs. There are always nontraded ones, but then you have nonliquidity risk," says Gary Alt, a certified financial planner and partner with Monterey Private Wealth in Monterey, California.

"The capital markets didn't understand this risk fully until 2008 and 2009 when all the money from banks dried up," Alt adds. "For investors accustomed to getting income from bonds, they better be ready for a wild ride with BDCs."

Although ETFs solve one problem by diversifying among many of the companies, they are still concentrating risk within a small, volatile sector of the financial services industry.

"Diversification is not the problem," notes Don Martin, a certified financial planner with Mayflower Capital in Los Altos, California. "The real problem is that the asset class is too risky. I would be very wary of investing in a BDC and would be suspicious of any high-yield product."

Given their high-risk profiles, BDCs are not a comparable substitute for Treasuries, mortgage securities, municipals or corporates in your portfolio.

If you are risk-averse, they are not for you. I wouldn't wait to see how they hold up in a down market. I would only approach them as an alternative for less than 2 percent of your holdings if you can add them to your portfolio to supplement - but not replace - your other income vehicles.

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