11% Yields From an Unknown Sector

If you’re an income investor, then you might think there’s a conspiracy against you.

Ten-year government bond rates reached record lows around the world last month: in Germany, the United States and Sweden they were under 1.50%. In Japan, the 10-year bond yield paid only 0.85%.

#-ad_banner-#Yields on many of our favorite high-yield plays often correlate with the 10-year government bond. So do we yield-hungry investors need to suffer from malnutrition?

In a word: “No.” You just have to know where to look.

For instance, I’ve told you before about the opportunities with mortgage real estate investment trusts (REITs) — an overlooked asset class offering yields above 10%. 

Today, I want to tell you about another, even less well-known investment class with yields of up to 11% — business development companies (BDCs). Most investors have never heard of these securities.

BDCs were created by an act of Congress in 1980 to fund small businesses that couldn’t easily raise capital. 

See, most BDCs make money by giving loans to small private companies. Most BDCs focus on the lucrative “middle market” — about 65,000 U.S. companies with revenue of between $10 million to $200 million. 

Since the financial crisis of 2008, banks have been less willing to loan money to these types of businesses. As a result, BDCs have been able to charge exorbitant rates for their loans. 

What does this mean for income investors?

As regulated investment companies, BDCs must pass along to investors at least 90% of taxable earnings each year. The majority of BDCs also distribute any capital gains to avoid being taxed on them at the 35% corporate tax rate.

Most BDCs provide “mezzanine financing,” loans that can convert to an equity interest and generate capital gains when the portfolio company is sold or taken public. The equity kicker is often given in warrants that allow the BDC to buy stock at a specific time and price if the company gains in value.

This means you benefit from the high rates of interest the BDC earns and from participating in a quasi-venture capital firm that profits from the growth of the companies in which it invests.

Venture-capital firms are usually privately-held and the exclusive preserve of the super-rich. But BDCs are publicly-traded and generally highly liquid. They can trade hundreds of thousands of shares daily, allowing investors like us to participate.

If BDCs sound like an interesting opportunity, then you’re not alone. I think they are too. But there are a few other things you should know before you invest.

For instance, a BDC’s two major expenses are borrowing costs to finance their loans and general and administrative expenses, including management fees. What remains is net investment income (NII). 

Even after expenses, net investment income may show rapid growth. But when calculated on a per-share basis, NII may be level or even decline. That’s because frequent share issues can offset total gains.

Action to Take –> Business development company Prospect Capital (Nasdaq: PSEC), for example, raised funds in at least five separate transactions in the past year and a half. These companies have to raise funds with share offerings because so much of their earnings are returned to investors. So be prepared for frequent share and debt issuances that can make for a volatile share price. Otherwise, you may find your blood pressure rising each time you read about your BDC tapping the financial markets. It’s standard procedure. 

The key is whether net investment income can cover distributions. If so, then the company can maintain its payments. For instance, Prospect Capital’s entire 10%-plus yield in fiscal 2012 is covered by net investment income.

Now, before you dive in, there is plenty more to know about business development companies. And in the coming weeks I’ll be bringing you more, including more information about one or two of the most interesting high-yield plays in the sector.