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The Smartest Way To Profit From These Ultra-High-Yielders

Friday, March 28, 2014 - 8:30am

Right now, the entrepreneurial spirit is in the public spotlight.

You can see evidence of this trend in popular television shows like "Shark Tank" -- where uber-entrepreneur Mark Cuban fields pitches from wanna-be startups -- "The Profit" and even the "Real Housewives" series.

Of course, the entrepreneurial spirit is especially evident in the business world -- ranging from crowdfunding platforms on the Web to the IPO market for companies ready to take their stock public.

Last year was a blockbuster year for IPOs, and the trend can be expected to continue in 2014. There were 222 initial public offerings in in the U.S. last year, which raised a total of $54.9 billion -- the most in the IPO space since 2000. Most excitingly for investors is that the average return for IPOs in 2013 has been an incredible 36%.

When you consider that dozens of additional IPOs are on tap in 2014 -- which Virgin Group founder Richard Branson recently predicted would be "the year of the entrepreneur" -- you can see the great investment potential in the business of business.

One way to ride this trend is to run your own business, as I'm sure many of you already do or are planning to do. Another way is to invest directly in the field of business development itself.

Investing in this trend used to be reserved only for investors wealthy enough to be qualified to invest in private equity. This once rarefied marketplace trades behind the scenes, and it's been quite profitable: Institutional private equity funds returned an average of nearly 18% annually from 2002 to 2012, trouncing the S&P 500's annual average of 7% in that time.

Thanks to a rising awareness of the private equity world -- driven in part by Bain Capital co-founder Mitt Romney's presidential campaign in 2012 -- a new breed of company has been brought to the public's attention.

Known as business development companies or BDCs, these firms invest in private, thinly traded and distressed companies with capital raised from a public offering. The number of BDCs has exploded over the past decade, growing from just four in 2005 to close to 30 today, with a total market cap of about $26 billion.

To qualify as a BDC, the company must distribute 90% of its taxable income to shareholders in the form of dividends. Additional tax advantages are gained if the BDC returns 98% of its ordinary income and 98% of its capital gains to shareholders. This is how BDCs are able to produce dividend yields of 10% or higher.

Since BDCs often invest in young or illiquid companies, there is tremendous risk as well as reward. The best way I have found to mitigate some of this risk is to diversify across a wide swath of BDCs. However, diversification mitigates only single-company risk, so if the economy turns negative toward BDCs, diversifying across BDCs won't help. (My colleague David Sterman recently examined the best BDC stocks on the market.)

Building your own portfolio of BDCs can be difficult and costly, so exchange-traded funds (ETFs) and notes (ETNs) of BDCs can be an ideal alternative. Before investing in either ETFs or ETNs, it helps to be aware of the differences between them.

Unlike ETFs, ETNs are issued by banks and are therefore dependent on their bank's credit: If the issuing bank's credit rating is cut, the ETN will be adversely affected. Also unlike ETFs, ETNs are guaranteed to track their underlying assets exactly.

Finally, ETFs are required to make yearly capital gains and income distributions, which are taxable events for investors. ETNs do not make these distributions, so investors can delay taxes until they've sold their ETNs.

Currently, my favorite BDC ETN is the UBS ETRACS 2xLeveraged Wells Fargo Business Development Company ETN (NYSE: BDCL). This ETN is double leveraged, meaning it moves twice as much as its underlying index, the Wells Fargo BDC Index. Its holdings include 28 different BDCs, so it is widely diversified across the BDC universe.

Risks to Consider: BDCs are inherently risky and very dependent on economic growth for their continued success. High returns and yields almost always have corresponding high risk.

Action to Take --> BDCL currently yields 15.7%, and its price has built a triple bottom at the $27 level.

Buying now with a stop at $26.50 and a nine-month price target of $30 makes sense. For investors who prefer to avoid leveraged investments, the UBS ETRACS Wells Fargo BDC ETN (NYSE: BDCS) may fit the bill. BDCS tracks the same Wells Fargo index, but it is less leveraged than BDCL, it pays a smaller yield, currently 7%.

P.S. My colleague Nathan Slaughter has been telling readers of his premium High-Yield Investing advisory for months about an enormous opportunity in real estate that was once reserved for America's privileged elite. Now regular investors have a chance to get in on the action. To learn more about Nathan's absolute favorite picks in real estate, read his special report by clicking here.

David Goodboy 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.