BDCL Still Attractive As Long As Interest Remain Low

| About: UBS ETRACS (BDCL)

Summary

BDCL's quarterly dividend paid in April 2016 is projected to be $0.7595.

This would be an annualized quarterly compounded yield of 20.8%.

The continuation of low interest rates is the key to high returns from BDCL.

While there are problems and high fees associated with some of the business development companies, the discounts to book value and high yields make BDCL attractive.

The ETRACS 2xLeveraged Long Wells Fargo Business Development Company ETN (NYSEARCA:BDCL) will soon be declaring its dividend for the quarter ending March 31, 2016. The dividend will be paid in April 2016. BDCL is an exchanged-traded note that employs 2X leverage to generate exceptionally high yields. There is an unleveraged ETN that is based on the same index, the UBS ETRACS Wells Fargo Business Development Company ETN (NYSEARCA:BDCS). Most of the 44 Business Development Companies that comprise the index portfolio upon which BDCL and BDCS is based have announced dividends with ex-dates in the first quarter of 2016.

American Capital Ltd. (NASDAQ:ACAS) and Harris & Harris Group Inc. (NASDAQ:TINY) do not pay dividends. MVC Capital Inc (NYSE:MVC) has not declared any dividend with an ex-date in the first quarter of 2016. Capital Southwest Corp. (NASDAQ:CSWC) pays semiannually and did not have an ex-date in the last quarter of 2015 but has declared one with an ex-date of March 11, 2016, so I did include it in the dividend calculation. Triangle Capital Corp (NYSE:TCAP) has declared a $0.54 dividend with an ex-date in the first quarter of 2016, however in the previous quarter it paid a $0.05 special dividend which it did not do in the first quarter of 2016. Likewise, Fidus Investment Corp (NASDAQ:FDUS)) has declared a $0.39 dividend with an ex-date in the first quarter of 2016, however in the previous quarter it paid a $0.04 special dividend which it did not do in the first quarter of 2016.

Newtek Business Services Corp (NASDAQ:NEWT) paid two dividends with ex-dates in in the first quarter of 2016. One for $0.35 with an ex-date of March 18, 2016 and one for $0.40 with an ex-date of January 5, 2016. In the last quarter of 2015 NEWT paid both a regular dividend of $0.50 and a special dividend of $2.69. Other changes from the last quarter of 2015 to the first quarter of 2016 include: KCAP Financial Inc (NASDAQ:KCAP) which reduced its first quarter of 2016 dividend to $0.15 from the previous $0.21. CM Finance Inc (NASDAQ:CMFN) which increased its first quarter of 2016 dividend to $0.3516 from the previous $0.3469. Oha Investment Corp (NASDAQ:OHAI) reduced its first quarter of 2016 dividend to $0.06 from the previous $0.12.

Taking all of those changes into account, from 41 of the 44 Business Development Companies who pay dividends with ex-dates in the first quarter of 2016, I projected that BDCL's quarterly dividend paid in April 2016 will be $0.7595. This is an decrease of 2.2% from the quarterly $0.7764 dividend paid in January 2016. Some of the decrease is due to the decrease in the indicative or net asset value of BDCL from $15.8369 on December 31, 2015 to the current $15.6466. The dividend of a leveraged ETN is impacted by the rebalancing of the portfolio each month to bring the amount of leverage back to 2X. If the value of the portfolio declines, portfolio assets must be reduced to maintain the leverage level. This reduces the dividend, is in addition to any reductions from dividend cuts by any of the components in the portfolio. Conversely, if the prices of the component securities increases, the dividend paid by the ETN will increase even if the components of the ETN do not change their dividends. That was the case in the first quarter of 2016. The relationship between the net asset value of MORL and the dividend is explained more fully in: MORL's Net Asset Value Rises - Implications For The Dividends.

The table below shows the weight of each of the components of the index upon which BDCL is based. The prices are as of March 18, 2016. The weights are the latest on the BDCL website. The table also shows the dividend rate, the ex-dates, and the dividend frequency of the components that pay dividends. In the frequency column "q" denotes quarterly, those that pay monthly have an "m", and the semi-annual payers are denoted by "s". Interestingly, the largest component of the index upon which BDCL is based, ACAS, with a weight of 10.71%, is one the 2 components that do not currently pay any dividends. The other component that does not currently pay dividends is TINY has a weight of 0.23%. Thus, 10.94% by weight of the components of BDCL do not pay any dividends now. If MVC, with a weight of 0.59%, is included as a non-payer, then 11.53% by weight of the components of BDCL do not pay any dividends now.

The outlook for BDCL depends on the level of interest rates and the equity markets. The equity markets themselves seem to be very dependent on the level of interest rates. Short-term rates in particular, will influence the returns on BDCL since the dividend varies inversely with the imputed cost of borrowing on the leveraged aspect of BDCL. The interest rate used to compute the imputed borrowing cost is based on LIBOR.

Everyone knows that short-term interest rates are controlled by central banks. In many industrialized countries the rates set by the central banks are negative. In Japan the 10-year government bond rate is now negative. The USA is an exception in the industrialized world in that the Federal Reserve has increased the rate it pays banks on their excess reserves deposited at the Federal Reserve to 50 basis points. In most other industrialized countries the deposit rate, which is their equivalent of the rate paid to banks on excess reserves deposited at the Federal Reserve, is negative. What does not get much attention is the question of what risk-free interest rates would be if there were no central bank intervention.

Government setting prices is now fairly rare in the free-market industrialized countries. There are still a few exceptions. The Federal Government still effectively sets the wholesale price of milk. Some politicians in the USA argue that some of the prices set by the free-market now should be replaced by government control. For example, some say the fast-food workers at McDonald's should be paid $15 an hour rather than the lower rate that now exists in the free-market. There are some politicians in the USA argue that the rates paid to savers in risk-free money market accounts are now too low.

The rates paid to savers in risk-free money market accounts are determined in a free-market, in that each financial institution is free to pay whatever it wants. Politicians in the USA who argue that the rates paid to savers in risk-free money market accounts are too low generally blame the Federal Reserve for the interest rates being too low. That assumes that absent intervention by the Federal Reserve interest rates would be higher. That assumption may not be correct.

The payment of interest on reserves is a direct transfer of billions of dollars from the American taxpayers to the banks. From its inception in 1913 until a few years ago the Federal Reserve never paid any interest on reserves, even in the 1980s when short-term risk-free rates exceeded 20%. In her most recent testimony a number of congress members were very concerned about the transfer of billions of dollars from the American taxpayers to the banks that paying 50 basis points on reserves entailed, Janet Yellen explicitly said that if the Federal Reserve had just raised the target rate on Fed Funds but not began paying 50 basis points on reserves, the market rates in the financial markets on loans and certificates of deposit would not have risen enough to accomplish the goals that the Federal Reserve wanted to accomplish by raising interest rates.

Usually it is fairly easy to determine what the difference in a price would be absent government controls. Clearly the free-market wholesale price of milk would be lower without Federal Government control. In the late 1970s prior to deregulation of interstate trucking rates I was tasked by the Interstate Commerce Commission to quantify the difference between the regulated trucking rates and what the free-market prices would be. That was fairly straightforward. To ship a certain load of goods from New York City to Buffalo, New York a road distance of 373 miles there was a certain free market rate. It cost more than double that rate to ship the same goods by truck from New York City to Philadelphia a distance of only 97 miles by road. Likewise the cost to ship from Los Angeles to San Francisco a distance by road of 382 miles was less than half the cost of shipping the same goods Los Angeles to Las Vegas. In both cases the difference between the non-regulated intra-state trucking rate and the regulated interstate rate was solely due to the regulation of trucking rates by the Interstate Commerce Commission. Another way to quantify the effect of regulation was to compare the trucking rates on raw produce such as live chickens or fresh tomatoes.

If a farmer wanted to ship live chickens or fresh tomatoes a certain distance there was a free market rate. If those same tomatoes or chickens were processed and put in cans and then shipped an identical distance as the farm to plant, the regulated rate was more than triple the price that the farmer would pay. This of course was because one group that had even more political power than the truckers and teamster unions, was the farmers. Thus, raw produce was exempt from the trucking rate regulation.

It is not as easy to quantify what a free-market rate on risk-free securities would be absent government intervention. Similarly it would be difficult to say what the rate on the US 10-year treasuries would be if the Federal Reserve was not asserting that they plan to raise short-term interest rates many times over the next few years. Might the rate on the US 10-year treasuries be closer to those in Europe or even Japan? The rates on 10-year Italian government bonds which were over 7% in 2012 are now 1.25%.

Without government intervention prices are determined by supply and demand. Interest rates are the price of loanable funds. At any given time and interest rate there is a supply of loanable funds from those who went to lend money. There is a demand loanable funds from those who went to borrow. Bond issuers are borrowers and bond buyers are lenders.

One complicating factor is that the supply and demand for loanable funds is also a function of credit conditions. At the height of the housing boom Alberto Ramirez whose occupation was strawberry picker and whose income was $14,000 per year was able to get a $720,000 mortgage to buy a house in Hollister California with no money down. There may be many strawberry pickers today who would like to get a $720,000 mortgage to buy a house with no money down. However, today there are probably no lenders who will issue a no money down mortgage that had a $5,200 monthly payment to someone who income is $14,000, while there were such lenders in 2006.

The supply and demand for assets that are risk-free in terms of credit is much narrower than the total supply and demand of loanable funds. Only governments can generally issue or guarantee bonds or deposits that are without credit-risk. Highly rated private corporations and financial institutions can issue debt that is considered close to credit risk free. It is the risk-free or close to risk free credit markets where most central banks intervene. That many lenders and investor are accepting negative interest rates give us a pretty good indication regarding the supply and demand for loanable funds in the risk-free sector.

While much attention is paid to how markets and institutions are dealing with negative interest rates, little attention has been focused on why there is such an imbalance between the supply and demand for loanable funds in the risk-free sector. My view is that the enormous shift in the tax burden away from the rich and onto the middle class world wide has put much more loanable funds into the hands of the wealthy who have a relative low marginal propensity to consume and a corresponding high marginal propensity to save. As I said in an earlier Seeking Alpha article:

..Since 1969 there has been a tremendous shift in the tax burdens away from the rich on onto the middle class. Corporate income tax receipts, whose incidence falls entirely on the owners of corporations, were 4% of GDP then and are now less than 1%. During that same period, payroll tax rates as percent of GDP have increased dramatically. The over-investment problem caused by the reduction in taxes on the wealthy is exacerbated by the increased tax burden on the middle class. While over-investment creates more factories, housing and shopping centers; higher payroll taxes reduces the purchasing power of middle-class consumers.
In an interview about the proposed "Buffett Rule", T.J. Rogers the CEO of Cypress Semiconductor Corporation (NASDAQ:CY) inadvertently illustrated the potential perils of overinvestment for an economy. Warren Buffett the CEO of Berkshire Hathaway Inc. (NYSE:BRK.B) had proposed the "Buffett Rule" which would impose a minimum tax of 30% on incomes above one million dollars. Rogers explained to Larry Kudlow on CNBC's Kudlow Report on May 16, 2012 why he opposed the Buffett Rule. Rogers said that he spends less than 1% of his income on his living expenses and invests the other 99% in creating new businesses and increasing the productive capacity of the businesses he already owns. If he had to pay taxes pursuant to the Buffett Rule he would not be able to invest as much. Clearly, someone who invests 99% of their income will see his wealth grow exponentially as long as his investments are at all productive. It would not take too many members of the top 1% investing 99% of their income before they would be unable to deploy their capital productively. This would be a classic example of capital accumulating faster than consumers' incomes. Consumers would be able to buy all the goods and services produced by the over investment…

As long as there is a much greater supply of loanable funds than the demand for them in the risk-free credit market, risk-free and near risk-free interest rates should remain low. Attempts by the Federal Reserve to push risk-free rates higher than what supply and demand would otherwise indicate, will only result in weaker economic activity. Lower rates are by far the best environment for leveraged ETNs such as BDCL.

Some readers have asked to see the details of my dividend calculations. I have changed my procedure, and now use the contribution by component method. It should give the exact same result as my previous method that could be called the total imputed dividends divided by the number of shares outstanding method. An example of that methodology using actual numbers can be seen in the article "MORL Yielding 24.7% Based On Projected June Dividend". In the total imputed dividends divided by the number of shares outstanding methodology, the number of shares outstanding appears both as a numerator and a denominator. Thus, the same result can be obtained by using the contribution by component method.

This method involves multiplying the net asset value of BDCL by weight of each component with an ex-date during the month prior to the month in question, and then multiplying that product by 2 to account for the 2X leverage. That product is then divided by the share price of the component. This is an imputed value for how many shares of the component each share of BDCL represents. Multiplying the shares of the component per BDCL share times the dividend declared by the component gives the contribution by component for each component. Adding all of the contributions of all of the components with an ex-date in the month prior to the month for which the dividend is being computed and adjusting for expenses, gives a projection for the dividend.

The index upon which BDCL is based is a float-adjusted, capitalization-weighted index that includes the Business Development Companies listed on the major exchanges. The fact that 11.53% of the companies that comprise BDCL are not currently paying dividends can be looked at with either a "glass is half full" or "glass half empty" perspective. On the bright side, there could be considerable room for an increase in the dividends paid by BDCL if those components not presently paying dividends were to resume them. On the other hand, the fact that 11.53% of the companies that comprise BDCL are not currently paying dividends could be seen as a warning that other components in the portfolio might also suspend dividends at some point in the future.

The premise for using 2x leveraged ETNs such BDCL to generate high income is that the extra income resulting from the spread between the dividends paid by the components of index upon which the ETN is based and the interest effectively paid by the ETN on the leveraged portion, should offset any declines in price by the business development companies in the index upon which BEDCL is based. With BDCL the weighted average of the dividends paid by the business development companies that comprise the portfolio is about 10% on a non-compounded basis. With 2x leverage the dividend yield on BDCL, before compounding is the 10% paid by the portfolio plus the amount generated by the leverage spread which is currently 10% less the financing expense based on three-month LIBOR, now 0.6%. Thus, before compounding, the dividend yield will be approximately 10% + 19.6% = 19.6%.

While the dividend yield on BDCL has been consistently above 20%, the prices of the business development companies that comprise the index upon which BDCL is based have declined so much that for some holding periods the total return on BDCL has actually been negative. This has exacerbated with the recent general aversion to most high-yielding securities whether they be junk bonds, mREITS or high-dividend closed-end funds.

With BDCL, concerns over high fees and problems with specific business development companies in the index and that sector in general have caused BDCL to underperform the equity markets in recent months. This has led many of them to trade at large discounts to book value. Computing the book value for business development companies can be problematic since many of their assets are not publicly traded. However, the higher yielding business development companies that compose the index upon which BDCL is based are generally thought be at historically large discounts to book value. This, could allow the slide in the market prices of the business development companies to reverse at some point.

The relatively high yield and high beta or systematic risk is consistent with the Capital Asset Pricing Model. One wrinkle is that for investors seeking higher yields, BDCL may actually be a relatively efficient diversifier, if those investors are now heavily invested in higher-yielding instruments that are very interest rate-sensitive. Previously, I pointed out in the article "17.8%-Yielding CEFL - Diversification On Top Of Diversification, Or Fees On Top Of Fees?" that those investors who have significant portions of their portfolios in mREITs, and in particular, a leveraged basket of mREITs such as the UBS ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL), could benefit from diversifying into an instrument that was highly correlated to SPY.

The UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA:CEFL) is highly correlated to SPY, while only 5% of the variation in daily returns for MORL can be explained by the daily variation in the S&P index. Since CEFL yields almost as much as MORL, this suggests that a portfolio consisting of both MORL and CEFL would have almost as much yield as a portfolio with only MORL, but considerably less risk. Adding BDCL to such as portfolio could result in a more efficient risk/return profile.

There is an unlevered fund that uses the same index as BDCS. BDCS could also be a good investment for those who want higher yields and want to use their own leverage to do so. Buying BDCS on a 50% margin would return a higher, or at least comparable, yield to buying BDCL for those who could borrow at LIBOR or some similar level. Many retail investors cannot borrow at interest rates low enough to make buying BDCS on margin a better proposition than buying BDCL. However, larger investors with access to low margin rates might do better by buying BDCS on margin.

Even some small investors could do better buying BDCS rather than BDCL, in some cases. For example, an investor might have $10,000 in a brokerage account in a money market fund and want to get at least some return by investing a small part of the $10,000 in BDCL or BDCS. Most brokerage firms pay just 0.01% on money market funds. The annual return on $10,000, at 0.01%, is $1 per year.

If this hypothetical investor were thinking of either investing $1,000 of his $10,000 in BDCL and keeping $9,000 in the money market fund, or investing $2,000 of his $10,000 in BDCS and keeping $8,000 in the money market fund, either choice would entail the same amount of risk and potential capital gain. This is because BDCL, being 2X leveraged, would be expected to move either way twice as much as a basket of Business Development Companies, while BDCS would move in line with a basket of Business Development Companies. For this hypothetical investor, his effective borrowing cost is the rate on the money market fund. Thus, his income from the $2,000 of his $10,000 in BDCS and $8,000 in the money market fund should exceed that of $1,000 of his $10,000 invested in BDCL and $9,000 in the money market fund, since his effective borrowing rate on the extra $1,000 invested in BDCS is less than what the imputed borrowing cost that BDCL uses.

As I indicated in the article "BDCL: The Third Leg Of The High-Yielding Leveraged ETN Stool," the 44 Business Development Companies that comprise the index upon which BDCL is based are a varied lot. Medallion Financial (TAXI) finances taxi cab companies. ACAS manages $20 billion worth of assets, including American Capital Agency Corp. (NASDAQ:AGNC) and American Capital Mortgage Investment (NASDAQ:MTGE), which are mREITs that are included in MORL.

Each of the 44 Business Development Companies that comprise the index upon which BDCL is based have their own specific risk factors. The power of diversification can make a portfolio now comprised mainly of high-yielding interest rate-sensitive instruments more efficient when BDCL is added to that portfolio.

As I explained in the article "30% Yielding MORL, MORT And The mREITs: A Real World Application And Test Of Modern Portfolio Theory," a security or a portfolio of securities is more efficient than another asset if it has a higher expected return than the other asset but no more risk, or has the same expected return but less risk. Portfolios of assets will generally be more efficient than individual assets. Compare investing all of your money in one security that had an expected return of 10% with some level of risk to a portfolio comprised of 20 securities each with an expected return of 10% with the same level of risk as the single security. The portfolio would provide the exact same expected return of 10%, but with less risk than the individual security. Thus, the portfolio is more efficient than any of the individual assets in the portfolio.

My projection of $0.7595 for the BDCL April 2016 dividend would be an annual rate of $3.038 This would be a 19.4% simple yield, with BDCL priced at $15.68 and an annualized quarterly compounded yield of 20.8%. If someone thought that over the next five years market and credit conditions would remain relatively stable, and thus, BDCL would continue to yield 20.8% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $257,544 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $20,800 first-year annual rate to $53,569 annually.

BDCL and CDCS components prices and dividends as of March 18, 2016

name

ticker

weight(%)

price

ex-date

dividend

freq

American Capital Ltd

ACAS

10.71

14.94

Ares Capital Corp

ARCC

9.93

14.28

3/11/2016

0.38

q

Prospect Capital Corp

PSEC

9.57

7.11

4/27/2016

0.08333

m

FS Investment Corp

FSIC

9.15

9.3

3/21/2016

0.22275

q

Main Street Capital Corp

MAIN

5.86

31.18

5/20/2016

0.18

m

Apollo Investment Corp

AINV

5.13

5.53

3/17/2016

0.2

q

Golub Capital BDC Inc

GBDC

3.53

17.24

3/3/2016

0.32

q

TPG Specialty Lending Inc

TSLX

3.5

16.75

3/29/2016

0.39

q

Hercules Technology Growth Capital Inc

HTGC

3.06

11.22

3/3/2016

0.31

q

Fifth Street Finance Corp

FSC

2.98

5

5/11/2016

0.06

m

Solar Capital Ltd

SLRC

2.89

17.49

3/22/2016

0.4

q

New Mountain Finance Corp

NMFC

2.88

12.67

3/15/2016

0.34

q

TCP Capital Corp

TCPC

2.84

14.38

3/15/2016

0.36

q

BlackRock Kelso Capital Corp

BKCC

2.77

9.13

3/16/2016

0.21

q

Triangle Capital Corp

TCAP

2.57

20

3/7/2016

0.54

q

Goldman Sachs Bdc Closed End Fund

GSBD

2.52

20

3/29/2016

0.45

q

PennantPark Investment Corp

PNNT

1.86

6.2

3/16/2016

0.28

q

Medley Capital Corp

MCC

1.57

6.89

2/22/2016

0.3

q

THL Credit Inc

TCRD

1.4

10.87

3/17/2016

0.34

q

PennantPark Floating Rate Capital Ltd

PFLT

1.18

11.57

3/16/2016

0.095

m

TICC Capital Corp

TICC

1.13

4.72

3/15/2016

0.29

q

Fidus Investment Corp

FDUS

0.99

15.11

3/9/2016

0.39

q

Gladstone Investment Corp

GAIN

0.85

7.04

3/17/2016

0.0625

m

Capital Southwest Corp

CSWC

0.84

13.94

3/11/2016

0.04

s

Medallion Financial Corp

TAXI

0.79

9.39

3/29/2016

0.25

q

Fifth Street Senior Floating Rate Corp

FSFR

0.78

7.55

5/11/2016

0.075

m

Monroe Capital Corp

MRCC

0.75

14.32

3/11/2016

0.35

q

Triplepoint Venture Growth BDC Corp

TPVG

0.75

10.92

3/29/2016

0.36

q

Capitala Finance Corp

CPTA

0.69

11.58

3/18/2016

0.1567

m

Garrison Capital Inc.

GARS

0.67

10.39

3/4/2016

0.35

q

Gladstone Capital Corp

GLAD

0.66

7.28

3/17/2016

0.07

m

Newtek Business Services Corp

NEWT

0.59

12.51

3/18/2016

0.75

m

MVC Capital Inc

MVC

0.59

7.22

q

Solar Senior Capital Ltd

SUNS

0.5

13.97

3/22/2016

0.1175

m

Stellus Capital Investment Corp

SCM

0.49

9.99

3/29/2016

0.1133

m

Horizon Technology Finance Corp

HRZN

0.48

11.43

5/17/2016

0.115

m

Alcentra Capital Corp

ABDC

0.44

10.8299

3/29/2016

0.34

q

American Capital Senior Floating Closed Fund

ACSF

0.39

9.6

4/19/2016

0.097

m

KCAP Financial Inc

KCAP

0.39

3.16

1/4/2016

0.15

q

OFS Capital Corp

OFS

0.34

12.31

3/15/2016

0.34

q

CM Finance Inc

CMFN

0.27

9.11

3/16/2016

0.3516

q

WhiteHorse Finance Inc

WHF

0.26

10.2

3/17/2016

0.355

q

Harris & Harris Group Inc

TINY

0.23

1.91

Oha Investment Corp

OHAI

0.23

3.18

3/29/2016

0.06

q

Click to enlarge

Disclosure: I am/we are long BDCL, AGNC, CEFL, MORL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.