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Business Development Companies (BDCs) offer some attractive opportunities for dividend stock investors. BDCs are now paying dividends in the 7-11% range - a level which is harder and harder to find in the market.

BDCs have some unique characteristics and investors often misunderstand the sector. BDCs typically lend to companies in the small to mid cap range and sometimes take an equity "kicker." Banks have reduced lending in this sector and so BDCs have some favorable opportunities to make loans on advantageous terms.

BDCs are limited to 200% leverage (borrowings can be no more than 100% of net asset value - thus, a BDC with $200 million in total assets can have no more than $100 million in borrowings). Some BDCs, like TICC, have avoided debt and many have less debt than permitted by the ratio limitation. BDCs are typically organized as Regulated Investment Companies (RICs); this means that they pay out 90% of earnings as dividends and that they do not pay income tax on earnings. The downside is that most dividend income is treated as ordinary income to the investor for federal tax purposes.

The BDC sector was absolutely crushed during the recent crash. Allied Capital (NYSE:AFC), one of the largest BDCs, was shorted by David Einhorn of Greenlight Capital, experienced a blizzard of negative publicity, discontinued its dividends and ran into problems with its lender. Most BDCs had to write down the value of their assets and this led many of them to have "ratio problems" (net asset value decreased below the level of borrowings) and covenant problems with lenders. As a result, many BDCs reduced or discontinued dividends and the retail investors who bought the stocks primarily for dividend yield bailed out.

At the bottom of the market, you could buy many BDCs for much less than 50% of book value. I got into the sector by buying AFC (Allied Capital debt) and then buying BDC equity at depressed prices. I reasoned that BDCs were misunderstood and tarred with the "financial sector" brush. In fact, BDCs have much less leverage than most financial stocks and so, despite all of these problems, I thought that no BDC would actually fail. Allied Capital was taken over by Ares (NASDAQ:ARCC) and some other BDCs had secondary offerings to build up net asset value but there were no actual failures.

Now, the sector has had a great run and valuations have returned to more "normal" levels with most BDCs trading modestly above book value and yielding between 7 and 11%. Investors interested in this sector should bear several things in mind. First of all, the tax treatment makes BDCs more attractive for IRAs and other non-taxable accounts. Secondly, the fact that BDCs typically pay out 90% of earnings as dividends means that dividends are not always as stable as they are for companies (like WMT, KO or PG) paying out a smaller percentage of earnings.

When a BDC's earnings decline, it is more likely that dividends will decline as well. BDCs find it difficult to grow because leverage is limited and most earnings cannot be retained; as a result, BDCs often have secondary equity offerings and these can affect the stock price.

BDC prices may increase if either the price book ratio increases or the book value increases. Most BDC price book ratios are now mostly in the 90-125% range and some of them have room for a modest increase. Book values can increase because some earnings can be retained. In addition, many BDCs wrote down the value of their portfolio assets during the crash and some of these assets may be liquidated for more than current book value. In addition, some BDCs invest all or part of their money in the equity of small companies and so have the possibility of substantial appreciation. Finally, some BDCs have continuing ratio and/or lender issues and are still trading well below book value.

Some of the BDCs that are producing good yields now are ARCC, FSC, AINV, PSEC, PNNT, HTGC, MCGC, GLAD, TICC, GAIN, and BKCC. NGPC is active in the energy area and offers a high yield, relatively low risk, way to invest in energy (primarily oil and gas). ACAS, SAR, and KCAP still have some issues and are trading at levels which offer significant potential for appreciation if those issues are favorably resolved.

These stocks are often lightly traded and each company has its own investment stategy and mix of legacy assets. A dividend stock investor should accumulate a diversified portfolio of these companies by learning about the assets and strategy of each company, buying on dips, and holding the stocks in tax advantaged accounts. This is a sector that requires an investor to roll up his or her sleeves and work up a sweat doing some digging into the facts with respect to each company (welcome to the "new normal"), but, in my view, even though the sector has had a great run, such an effort will be rewarded.

Source: Why Dividend Stock Investors Should Consider BDCs