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This piece will deal with several alternative vehicles for getting some exposure to Business Development Companies (BDCs) other than by buying BDC stocks. I have frequently been asked about a closed end fund which invests in BDC stocks. The fund, First Trust Specialty Financial (FGB), trades like a stock and is priced based on market action rather than on the value of its holdings. On Thursday, FGB closed at $6.38 a share which was a 4.5% discount to the value of its holdings (which consist almost entirely of publicly traded stocks). In this sense, it offers an opportunity to buy a basket of securities at a modest discount.

FGB does not invest exclusively in BDC stocks. As of the end of its last reporting period, roughly 17% of its holdings were mortgage REITs - the largest of which was Annaly (NLY). It also held a smattering of other miscellaneous equities in the insurance and other industries. In the BDC sector, its largest holding was Ares (ARCC), followed by PennantPark (PNNT). It held a diverse mix of BDCs which clearly make up the dominant part of its portfolio.

As a closed end fund, FGB is permitted to use leverage (to borrow and thereby buy a total amount of assets larger than its net value). It appears that it has used roughly 20% leverage, well below the limit allowed to closed end funds. If FGB were to leverage itself up to the limit, then it would be required to sell off assets as asset values declined because the decline in asset values would automatically drive it over the leverage limit. At this point, there does not seem to be any danger of this happening.

As a closed end fund and unlike an open end fund, FGB has no obligation to sell off assets when shareholders sell shares in the fund. If shareholders sell shares in FGB, FGB really has no obligation to do anything at all. Thus, FGB is protected from the "buy high, sell low" danger that redemptions can create in an open end fund. On the other hand, investors must be aware that, regardless of the value of FGB's assets, the share price of FGB itself can go up or down based on market value. This manifests itself in variations in the discount to net asset value (NAV) reflected in the FGB share price.

FGB incurs certain operating costs. As of the most recent reporting period, these costs were approximately 1.5% of NAV or 1.3% of total assets (total assets are greater than NAV due to leverage). While this is not a large number nor is it "out of line" - investors who are trying to get an 8 or 9 percent total return on their investment should bear in mind that this cuts into that return rather sharply.

In a fluctuating and fickle market, FGB's discount to NAV has bounced around over the last couple of years. In early August of this year the discount got into the 8 and 9 percent range and reached 11 percent on August 9. I would recommend watching it closely with an eye to getting in when the discount becomes particularly generous.

In addition to FGB, I am aware of two publicly traded debt securities which I have traded from time to time. These are both debts of Ares Capital (ARCC) and the symbols are AFC (which was originally a debt of the old Allied Capital before it was acquired by ARCC) and ARY. In each case, one share equals a $25 face amount obligation of ARCC to pay you back (like a small bond). AFC has a coupon of 6.875% of face value and ARY has a coupon of 7.75%. AFC matures in 2047 and is subject to call at $25 on April 15, 2012. ARY matures in 2040 and is subject to call at $25 on October 15, 2015. With a higher coupon ARY trades at a higher price and closed Thursday at $24.95, while AFC closed at $23.25.

ARCC is in good shape and there is no reasonable possibility of a default. ARCC has $4.9 billion in assets and liabilities of only $1.8 billion so that even in a liquidation, the bondholders should get paid off in full.

I do not think that either of these is going to provide exciting returns to investors from these prices, although AFC could be called in April and ARY could trade at a premium for a while in an ultra low interest rate environment. But back in August, AFC dipped below $19 and I grabbed a bunch. These securities are lightly traded and in a volatile market they can be priced irrationally. I have a soft spot in my heart for AFC because I bought a bunch in early 2009 for less than $7 a share and rode a very nice, very long wave and collected more than 20% interest on my initial investment while I enjoyed the ride. While I doubt that the prices will ever get back there, the irrationality of the market and the extreme volatility we sometimes see could produce a real bargain in one of these and an investor should be keeping his or her eyes open to be ready to pounce when the opportunity arises.

Source: BDC Review: Part 7 - Alternative Vehicles For Investing In BDCs