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3 Warning Signs Of A Dangerous Dividend

Wednesday, May 22, 2013 1:00 PM

Our team of analysts here at StreetAuthority endeavors to spot value wherever it may lurk, but we're partial to a few solid investment angles.

One of our favorites: business development companies (BDCs), which we have written about on numerous occasions. My colleague Andy Obermueller recently provided a helpful primer on BDC stocks.

As Andy and others have noted, BDCs offer divided yields ranging from good to great. Those high yields also appear sustainable, thanks to the diversified investment approach that these BDCs pursue. As Andy noted, "BDCs offer a surprisingly safe way to invest in high-risk areas on the cutting edge."

While Andy and others focus on some of the top stock picks in this industry, I like to reduce risk even further by taking a "fund of funds" approach. These BDCs already individually own dozens of companies, and the exchange-traded funds (ETFs) that focus on BDCs, by proxy, own hundreds of portfolio companies through their holdings.

Which BDC ETF appeals most to you is a matter of style. Here's a look at four of them.

1. Market Vectors BDC Income ETF (NYSE: BIZD) -- 7.4% yield
Launched in February, this fund seeks to own the largest BDCs, with each holding given a weighted position (and rebalanced) according to its market value. For example, both American Capital (Nasdaq: ACAS) and Ares Capital (Nasdaq: ARCC) each account for roughly 14% of the fund, as they are the largest BDCs around. (Prospect Capital (Nasdaq: PSEC), Apollo Investment (Nasdaq: AINV), and Fifth Street Finance (Nasdaq: FSC) round out the top five.)

The 30-day SEC yield for this fund is a solid 7.4%, yet investors may be thrown by the fact that this ETF appears to sport a 7.7% expense ratio. That's actually what the BDCs themselves charge, on average, in terms of management fees; it's not a fee charged by this ETF. The actual expense ratio is a more reasonable 0.4%.

2. ProShares Global Listed Private Equity ETF (NYSE: PEX) -- 4.6% yield
While BDCs are primarily a solely domestic entity, thanks to U.S. investment laws that created the BDC regulatory framework, foreign firms take a similar approach, though are often classified simply as private-equity firms rather than BDCs. This fund tries to capture the global players, with 55% of the ETF's portfolio invested in U.S.-based BDCs and the other 45% in foreign private-equity firms.

This global approach carries a clear drawback. Private-equity firms are not required to pay monthly or quarterly dividends, as the BDCs are. As a result, they are more suited to capital appreciation than income streams, which explains why this fund carries a niche-low 4.6% yield. Still, this ETF is likely to generate stronger share price gains than its peers, thanks to that private-equity weighting.

3. UBS E-TRACS Wells Fargo BDC ETN (NYSE: BDCS) -- 9.8% yield
4. UBS E-TRACS 2x BDC Index ETN (NYSE: BDCL) -- 18% yield

UBS is a virtual old hand in this niche, having launched a pair of ETNs (exchange-traded notes, which are slightly different than ETFs) back in early 2011. Each note is based on the Wells Fargo BDC index, which is a market-weighted basket of all publicly traded BDCs in the U.S. That index surged 33% last year, highlighting the increasing appeal of the BDC approach. Despite those gains, the UBS E-TRACS Wells Fargo BDC ETN sports an impressive 9.8% dividend yield.

Investors can take that further by investing in the UBS E-TRACS 2x BDC Index ETN, which is like the BDC ETN, but on steroids. UBS' fund managers borrow money at very low interest rates and then reinvest the proceeds back into BDCs, magnifying the payouts. As a result, the dividend yield is a stunning 18%.

Does such a high yield imply that this dividend will soon be cut? Not necessarily. As long as borrowing costs remain low (the one-year LIBOR currently stands at 0.7%), then the use of leverage will pay off handsomely.

Even when LIBOR moves back up toward the 4% mark, the cost of capital will still be low enough to help support double-digit yields. The real risk here is a recession, which has proven to be a tough economic environment for BDCs as they become harder pressed to squeeze dividend payments out of their portfolio companies.

Risks to Consider: That last comment on the leveraged BDC ETN applies to all BDC-related investments. Indeed this asset class fared very poorly in 2008, as industry leader American Capital plunged on fears of a liquidity crisis.

Action to Take --> The BDCs rebounded from the 2008 crisis quite nicely, and as long as the U.S. economy remains on solid footing, they should continue to generate robust yields. These ETFs (and ETNs) help to capture those yields while reducing risk even further, thanks to their diversified approach.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.