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Business Development Companies (BDCs) are a creature of what is sometimes called the "40 Act" and are similar in some ways to closed end funds. BDCs generally invest in loans to small and middle sized businesses, although BDC strategies vary enormously. They are limited in leverage (debt can be no more than one half of total assets) and are generally regulated investment companies (RICs) which are exempt from corporate taxation but are required to pay out 90% of earnings as dividends. Dividends are generally taxed to the recipient as ordinary income. I have written a series of articles analyzing all current BDCs starting with this article.

The obvious advantage of BDCs is that they tend to pay high dividends. Many BDCs are currently paying dividends in the high single or low double digit range as illustrated by the table below.

Of course, dividend investors are aware that there are multiple strategies for generating high dividend yield and BDCs are not the only to achieve high dividends. In fact, agency mortgage REITs tend to pay even higher dividends. This article is not intended to persuade investors to invest SOLELY in BDCs; rather, the suggestion is that a reasonably diversified dividend portfolio should include some investment in BDCs. Here are some of the advantages of BDCs for dividend investors.

1. Limited Leverage - There is a TV show entitled "Leverage" starring Timothy Hutton (who has aged well and doesn't look that much older than he looked when he was the youngest male Oscar winner in history for "Ordinary People"). I think that there is an implication in the title that "leverage" is a good thing. In fact, leverage is a mixed blessing. In the recent financial crisis, leverage led to calls on loans resulting in wholesale liquidation of assets at the very bottom of the market. An entity with assets of $100 million and debt of $80 million will experience a 50% decline in book value or net asset value if its gross assets decline in value by 10%. Worse yet, it may be required by its lenders to sell those assets at the very time the market is least hospitable. Agency mortgage REITs often have debt levels over 80% of gross asset value and are exposed to much more leverage than BDCs (this is offset by the fact that they tend to hold safer assets). In comparing agency mortgage REITs and BDCs, you are really comparing a strategy of holding safe assets with a lot of leverage to a strategy of holding riskier assets with much less leverage. For example, a BDC with no leverage at all (and many of them have no leverage) but with mezzanine and subordinated loans as assets has the advantage of not being required to dispose of its assets at the bottom of the market when they have declined in value.

2. Transparency - In putting together my Desperately Seeking Yield series of articles (which starts here), I read a lot of balance sheets. One of my few hard and fast rules of investing is - "If you don't understand it, don't buy it". As a general, but not absolutely universal, matter, BDCs have relatively easily understandable balance sheets. You can generally get a reasonable sense of the nature of the assets and their performance. There is a limit on how large a percentage of the assets can be focused on any single investment which is also a positive. I find it harder to understand the balance sheets of certain mortgage REITs and, because of high levels of leverage, relatively minor miscalculations can have a big impact on the value of what you are buying.

3. Limited Exposure to Increasing Interest Rates - Any yield oriented investor has to be concerned with the prospect that some day (perhaps even before global warming turns Baffin Island into a beach resort) interest rates will increase. A dramatic increase in interest rates will adversely effect almost any yield oriented strategy. The good news for BDCs is that they tend to make relatively short term (3 to 5 years) business loans and many of the loans are floating rate. This means that, over a reasonable period of time, a BDC will be able to earn higher interest income if interest rates increase. Because of Transparency, an investor will be able to make a reasonable assessment of this issue by examining a BDC financial statement which will generally reveal the term length average of the loan portfolio as well as the percentage of floating rate loans. I am not saying that BDC stocks will not go down if interest rates go up sharply, but, after a reasonable interval, BDC earnings should increase and stocks should correct.

There are some downsides. Dividends are generally taxed as ordinary income, although that may not differentiate them for other companies if the special tax treatment for dividends does not survive the "fiscal cliff" resolution. Investors are unlikely to experience major growth in share price because most of the earnings are paid out as dividends and BDCs often raise funds through secondary offerings. Finally, in a deep recession, BDCs will experience default problems on some of their loans and this can produce significant declines in share price and dividends.

In the table below, I am listing three BDCs which I consider appropriate core holdings for dividend investors. They each provide a generous dividend yield. In addition, none of them is priced at a level significantly above Net Asset Value. Finally, each of them is large enough to provide internal diversity of investment holdings and to take advantage of scale economies.

BDCPriceDividendYieldNAVTotal Assets
Ares Capital(NASDAQ:ARCC)$16.08$1.579.8%$15.74$5.94B
Prospect Capital (NASDAQ:PSEC)$9.89$1.2211.6%$10.88$2.26B
Fifth Street Capital (NASDAQ:FSC)$10.00$1.1511.5%$9.85$1.20B

In addition, I recommend American Capital (NASDAQ:ACAS) as a long term holding even though it does not currently pay a dividend. ACAS is trading at $11.20 a share, which is an enormous bargain given its NAV of $17.39 a share. It will gradually trade up to NAV, with the NAV itself likely to continue to increase and will begin paying a dividend in the next couple of year. I also like Central Southwest Capital (NASDAQ:CSWC) - another long term hold with a great track record selling at a discount to fair value.

A review of the series of articles I have completed will provide the reader with other names in the sector which are attractive. The BDC sector is dynamic with new companies entering all the time so that there are lots of opportunities to identify attractive investments.

As I have said before, I do not recommend that an investor sink everything he or she has into BDCs but I do think that they help diversify a dividend portfolio.

Source: Why BDCs Should Be Included In Your Dividend Portfolio