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Business development companies, or BDCs, offer investors high-single-digit and double-digit dividend yields. The sector also shows improving asset quality and has ready access to capital, says Vernon C. Plack, CFA, senior managing director at BB&T Capital Markets. In an October 3, 2011, interview, Plack states:

Currently, the S&P 500 is yielding about 2.2%, while the BDC industry is yielding about 8.7%. The average relative multiple has been 4.6 times, and the group is currently trading at four times, within the normal range, which leads us to believe the group is currently fairly valued.

BDCs can invest in a wide variety of company security classes and make those investments available to the public. Steve Klinsky of New Mountain Finance Corporation put it this way in an October interview:

Debt is inherently less risky than the equity in the same company because it is senior to the equity, and we had already extensively researched many of these companies and industries through our private equity work. So in 2008 we took $300 million of our private equity fund and started using it to buy debt, and we've invested in close to $1 billion of debt issues overall since then, both through purchases and through direct loans. We've named the debt effort New Mountain Finance Corporation and took it public on the New York Stock Exchange in May of this year. New Mountain Finance is organized as a business development corporation, BDC, essentially as a closed-end debt fund that we manage on behalf of the public.

BDC equity, however, is expected to experience volatility tied to fluctuations in the capital and equity markets in the near term, as these investment vehicles require outside funding in order to expand operations, says Arren Cyganovich, CFA, vice president and research analyst at Evercore Partners.

[BDCs] have to pay all of their taxable earnings out in the form of dividends, which means that if they want to grow, they typically have to rely either on issuing equity or levering up their balance sheet. They have limits though in terms of their leverage as a BDC. BDCs can’t exceed one-to-one debt to equity.

Balance sheets in the sector, however, are strong overall, says John Stilmar, director at SunTrust Robinson Humphrey. He says BDCs have minimized their investments in debt and taken over more defensive positions.

This space has matured greatly in the quality of the managers, and the industry has understood the values of risk management in managing the exposures of individual investments. This has yielded a much stronger space.

Company Ticker Price p/e Market Cap Dividend Yield
Areas Capital Corporation (NASDAQ:ARCC) $15.69 8.86 $3.22 B 0.36/9.18
PennantPark Investment Corp. (NASDAQ:PNNT) $10.25 25.49 $468.32 M 0.28/10.93
Apollo Investment Corp. (NASDAQ:AINV) $6.68 N/A $1.32 B 0.28/16.76
American Capital, Ltd. (NASDAQ:ACAS) $7.11 3.34 $2.40 B N/A
Harris & Harris Group, Inc. (NASDAQ:TINY) $3.64 N/A $112.84 M N/A
New Mountain Finance Corp. (NYSE:NMFC) $13.24 N/A $141.64 M 0.30/9.06
Saratoga Investment Corp. (NYSE:SAR) $12.56 N/A $41.16 M 0.60

Both Stilmar and Sanjay Sakhrani of Keefe, Bruyette & Woods have pointed to Ares Capital Corporation as a stock to watch.

Stilmar said:

If we look at Ares, ticker ARCC, and look at August being the time period in which we really started seeing the acceleration of the descent of the equity market and compared the stock performance to the KBW Bank Index called the BKX, which is broadly used as a proxy for financial performance, Ares has outperformed the BKX pretty materially. Not all BDCs can say that, but this serves as a strong data point that investors will support good managers in a defensive structure like the BDC.

Sakhrani gives Ares an “outperform” rating, and reminds that ARCC is one of the larger companies in the BDC space.

The reason we like Ares is they have a lot of liquidity and they’ve been waiting to deploy that liquidity when things got choppier,” he said. “And it seems to us that the competitive dynamic that existed before has eased somewhat, and you’re seeing a pickup in terms of yield, so I think they can probably deploy that liquidity in a more favorable investing environment today.

Source: Business Development Company Dividends Far Outshine S&P 500 Yield