BDCL: A 14% Yielder, If You Can Tolerate The Volatility

Summary

• BDCL aims to deliver double the performance of the Wells Fargo BDC Index.
• This results in the note paying out an incredible 14.4% distribution at its current market price.
• The note is much more volatile than its sister BDCS due to the leverage.
• Business development companies have seen their dividends under pressure due to rising interest rates, which also pressures the note's distribution.
• BDCL thus offers a very high level of current income to investors that can stomach its volatility.

One of the more common investment vehicles, if not surprisingly underfollowed ones, among income investors is business development companies, commonly called BDCs. These vehicles function very similarly to private equity firms in that they provide funding, typically in the form of debt, to privately-held companies and then generate their income from the interest paid on these loans. In addition, much like mortgage REITs, BDCs can also borrow money to make these loans and profit off of the interest spread between the rate it receives and the rate it pays. I discussed one BDC, Hercules Capital (HTGC), in a recent article but there are numerous other ones, most yielding around 10%. There is a way to get an even better income yield off of these vehicles however and that is to invest in the UBS ETRACS 2xLeveraged Long Wells Fargo Development Company ETN (NYSEARCA:BDCL).

About The ETN

The ETRACS 2xLeveraged Long Wells Fargo Business Development Company ETN is designed to track a leveraged investment in the Wells Fargo Business Development Company Index. This index is, according to Wells Fargo Securities, designed to track the performance of all business development companies that are listed on either the NYSE or NASDAQ. The index only includes those companies that are specifically registered with the SEC as business development companies and is market capitalization-weighted.

Some of the companies that make up the Wells Fargo index will be familiar to investors in the sector, others are much lesser-known names. Here are the companies that make up more than 1% weighting in the index:

Source: UBS

As the name implies, the note is designed to deliver double the performance of this index. That is perhaps its greatest appeal, particularly when it comes to distributions.

Distributions

As already mentioned, business development companies are among the highest-yielding firms trading in the American markets. BDCL actually delivers double the yield of the companies in the index by virtue of its 2x leverage. This causes the note to have a current distribution yield of 14.40%, which is roughly the average yield that it has had over the past year:

Source: UBS

It is worth noting that these distribution payments are classified as interest payments and are therefore taxed at ordinary income rates as opposed to the more favorable qualified dividend rates. As such, investors should consider holding their notes in a tax-advantaged account such as an IRA as opposed to a fully-taxable account.

It is also worth noting that this distribution is not actually backed by the companies in the index paying out dividends. Instead, BDCL is an unsecured debt obligation of UBS (UBS) on which the company simply promised to pay out double the returns of the index that was already discussed. As such, there is always the risk that UBS will default and not pay the distribution, which you would not have with a fund structure. While UBS is one of the largest and most well-capitalized banks in the world and is highly unlikely to default, this is still a risk.

Performance

While BDCL is not technically a leveraged fund, it does behave like one. As such, we can expect it to deliver the performance of a 2x leveraged investment in the underlying index. This is something of a double-edged sword since, while leverage does increase gains, it also increases losses. We can thus expect the ETN to outperform the index on the way up but also significantly underperform it on the way down. Fortunately, BDCL also has a sister note, BDCS, that is designed to track the index exactly (minus fees, of course). Let us see how the two perform against each other:

Source: ETFDB

Here we can see that BDCL has indeed been much more volatile than its sister note. This is a fact that may turn potential investors off from the note, particularly when the price is declining. To my mind then, the primary appeal here is that the very high yield as opposed to a way to bet on the direction of the index, but the note's doubled performance of the index may appeal to a directional trader as well.

Business Development Companies and Interest Rates

As everyone reading this is no doubt well aware, the Federal Reserve has been engaged in a quantitative tightening program meant to raise interest rates in the United States. this has resulted in interest rates rising throughout 2018 and this is one thing that poses a significant risk to BDCL. As already mentioned, BDCs frequently borrow money in order to make loans and profit off of the yield spread. Unfortunately, rising short-term interest rates have been compressing the yield spread at many BDCs, which has forced them to reduce their dividends due to lower cash flow. As BDCL bases its distribution on the dividends paid by the companies in the index, the note will reduce its distributions accordingly. This resulted in a 12.5% distribution cut in the fourth quarter of 2017. The note's distribution for the first quarter of this year was also lower than the previous one, although the second quarter one was a slight increase from the first. It is quite possible that we will see further distribution cuts in future quarters should this trend continue.

Conclusion

In conclusion, BDCL is a very high-yielding ETN that may be appealing for income investors. It does, however, require an iron stomach to handle its volatility, which can be quite severe due to its leveraged nature. In addition, the rising interest rate environment is causing some of the underlying components to reduce their dividends and this is naturally causing the note to reduce its distributions. However, yield seeking investors may still want to take a look.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.