After years of being ignored by the sponsors of Exchange Traded Funds and Exchange Traded Notes, the BDC industry has suddenly become the flavor of the month. We’ve been writing about the subject here, most recently on May 2, about Van Eck’s BDC ETF. Last week there was another development worth noting: the launch of the first 2X leveraged BDC ETN. The new instrument, which trades under the symbol BDCL, has the ungainly name of “ETRACS 2X Leveraged Long Wells Fargo Business Development Company Index.”
We had a look at the Product Profile prepared by the new ETN sponsor UBS, and have a few observations for anyone intrigued by this new offering.
LINKED TO THE WELLS FARGO BUSINESS DEVELOPMENT COMPANY INDEX
First of all, the ETN is based on the Wells Fargo Business Development Company index, which we wrote about back on April 21. We won’t recap the details of that article but it’s worth reading to understand the composition and methodology behind the Index. As we said at the time it’s not a perfect representation of the BDC market because it does not include all publicly traded BDCs due to capitalization and liquidity limits and the larger market capitalized BDCs are limited to a weighting in the Index of 10.0%, even if their actual size would dictate a bigger role by the reasonable but still arbitrary rules set up by Wells Fargo. Still, it hews closer to the composition of the BDC industry than the Van Eck index, which also throws finance companies into the mix.
A YIELD IN THE MID TEENS
Anyway, the new ETN adds a unique new feature (in the BDC space): 2X leverage. That means that for every dollar of equity invested in purchasing BDC stocks, the ETN borrows another dollar in the form of debt. Given that most BDCs are paying relatively high dividends of 8%-9%, the result of leverage is that the ETN is one of the highest yielding “equity” instruments you’re going to find anywhere on Wall Street. UBS estimates the current yield level at 14.57%, after fees and the cost of interest. That means an investor in the ETN will receive a distribution on a quarterly basis equal to the dividends received by the sponsor from the BDCs in portfolio. An investor will also benefit twice as much from any improvement in the BDC Index stock price. (There are 26 BDCs in the Wells Fargo Index at this time, but that number may change given the flurry of new issue activity in recent weeks and upcoming). For anybody considering buying BDCs on margin, this is a superior alternative, both in its elegant simplicity (just buy the ETN, rather than setting up a margin account etc.) and due to the very inexpensive borrowing rate the ETN is able to access. If you were paying 4%-5% at Fidelity or Ameritrade the projected dividend yield would be substantially lower. The downside, though, is that you cannot pick and choose which BDCs are included in the portfolio. You have to go with what the Wells Fargo Index is invested in.
Of course, with leverage and higher return comes risk. If the BDC Index drops, a holder of BDCL will face twice the drop of an unleveraged ETF or ETN. You don’t get 15% returns without some element of risk. Moreover, there is the technically complicated subject of “correlation and compounding risk.” In a nutshell, and this is probably better explained by specialist ETF/ETN commentators, there is no guarantee that the performance of the Fund will actually match (or “correlate”) the underlying Wells Fargo Index. The Fund resets every month and this might cause the Fund’s performance to differ from the direction of the Index. As the Product Description says: “…Significant adverse monthly performance of your ETNs may not be offset by subsequent beneficial monthly performances of equal magnitude.” This is a standard problem with many ETFs and ETNs but bears noting.
MORE RISKS ENUMERATED AND BRIEFLY DISCUSSED
As long as we’re on risk, one of the downsides of investing in an ETN is that the instruments are “senior unsecured debt obligations of …UBS.” As goes UBS, so goes the ETN. Not much of an issue now, but it could matter in the next financial crisis. Also UBS has the right to call the ETN (probably if it’s not making them a profit) starting a year from now. If your investment is down and you were projecting to make it up in the future from dividends and capital appreciation you might be out of luck if UBS chooses to yank the ETN from the market at the then-market price. Finally there’s the tax treatment. UBS does not even try to cover that kettle of fish, just saying “Significant aspects of the tax treatment of the ETNs are uncertain. You should consult your own tax advisor about your own tax situation.”
ACTIVITY TO DATE
The new Fund launched on May 24 and volume has been light. UBS has the right, but not the obligation, to support the new instrument by buying and selling in the market. If that’s been occurring it’s been on a small scale.
WORTH IT ?
Of course whether an investment in BDCL is worth the uncertainties involved will vary by individual. However, in a world of me-too financial products, this is (for the moment) a unique offering. Moreover, the Wells Fargo Index on which it is based is relatively broad based and sufficiently liquid at this stage. UBS is a well known and respected sponsor. The 0.85% fee charged is reasonable given the access to 2x leverage. If you believe the BDC industry still has room to run in terms of stock price appreciation, or at least is unlikely to fall materially, the ETN may be a good investment. Even if the stock price goes nowhere, the high dividend return will generate a superior return. If we’re on the edge of a sustained downturn in BDC stock prices (which we don’t believe, but you never know) then neither this ETN nor the other BDC industry linked instruments out there are going to make good investments. Decisions, decisions.