Is The Timing Right For BDCs And Their High Dividends?

Includes: BDCL, BDCS
by: Dividend Don

My investment focus is on growth and income with high yielding dividend stocks. I am nearing retirement and I love dividends, but I love them even more if they grow. As most of you know, many high dividends are high (on a percentage basis) because the prices of the stocks have been battered. To add insult to injury, they are often battered for good reason, and often end up cutting those hefty dividends, leaving you will a smaller income. For that reason, and understandably, many people shy away from high yielding stocks. However, I look at it a different way. I have found that there are always some high yielders that don't fit that profile and are sometimes underpriced because people assume they do. I am on a mission to find them. I will look at BDCs (Business Development Companies) in this article as potential candidates for my personal income with potential growth portfolio.

My conclusion will be to consider UBS E-TRACS Wells Fargo Bus Dev Comp ETN (NYSEARCA:BDCS) or UBS E-TRACS 2x Wells Fargo Bus Dv Cm ETN (NYSEARCA:BDCL) or neither depending on your outlook for the economy.

My overall assessment of where the economy is headed

The economy has had a large impact on BDCs in the past and likely will in the future. So, I'm going to take my best shot at where the economy is headed first. Then, I will look at BDCs in that light.

Don waves his hand over his crystal ball, and asks the ball how the economy will do for the next couple of years. First, the ball laughs at him. Then it says "here's your answer" and it fills with fog and tell him that it is very clearly unclear. I do believe the crystal ball has a point, as the trends are not clear quite yet. This may set off a firestorm of controversy, but here's my opinion:

1) Housing - House financing was a key factor in bringing the economy down, and I'm betting it will be the key to bringing it up. It seems kind of obvious, but I believe that the biggest reason banks have gotten stingy about lending money to consumers is because consumers have less equity in their homes. We have had house price deflation since 2008, and it is a very serious problem. The Fed official who is still concerned about inflation needs to be quietly gagged and removed. We need house price inflation. Maybe it's a concern eventually, but no time soon. When people have equity, banks will lend. When the banks lend, people will spend. When people spend, the economy gets better, as more jobs are created to fill newly created demands.

The good news - Housing has shown steady improvements in pricing and sales for several consecutive months. In fact, it has been substantially above expectations and appears to be a trend. It will take a number of years to push housing prices up to where they need to be for people to recoup their recession losses, but every time your house price goes up, you have a little more equity, and the banks will be a little more friendly to your loan requests.

2) China - When China slows down as it has, demand for oil and coal slow down and prices go down. Good news, right? It may help prices at the pump a little, but it hurts all the companies that are creating jobs in those sectors. So, this is a tough one to figure.

Good new again? - Maybe more good than bad. If the housing market takes off as #1 above suggests and consumers buy more, whether we like it or not, they will buy more "made in China" goods, as that is most of what is available. This would help to get both China and the US growing again. On the downside, it would likely keep gas prices up, but it could also create more demand and thus more jobs in the gas, oil, and coal fields (China still uses a lot of coal).

3) Europe - Many European economies look like they are going to be in some trouble for a number of years. It may not be as bad as once thought, but it will likely go on for a very long time. These areas will likely continue to have less demand for American goods and services.

Not so good news - The impact so far on this round of earnings has maybe been a little less than expected, but it will likely continue to be a problem for some time to come.

4) The Fiscal Cliff - In a nutshell, many programs are scheduled to be cut at the end of this year. Included are the end of last year's temporary payroll tax cuts, certain tax breaks for businesses, shifts in the alternative minimum tax, the defense budget, Medicare, and much more. Congress needs to get their act together by Dec 31st 2012.

Maybe bad news, but not so bad longer term - According to the CBO (congressional budget office), while the combination of higher taxes and spending cuts would reduce the deficit by an estimated $560 billion, the policies set to go into effect would cut gross domestic product by four percentage points in 2013, sending the economy into a recession (i.e., negative growth). Many people, including me, believe that the most likely scenario is that we will not make the cuts, our US debt will again get downgraded, and that it won't make any difference in a slow recovery just like the last downgrade didn't. The economy appears to be recovering in spite of the last downgrade. I don't expect this to be any different. Where else are investors going to put their money? Outside the US? Maybe a very few. My best guess is that it will take center stage right after the election and make for a very turbulent time for stocks and a buying opportunity. Then it will be a big yawn.

So, I suspect we are headed for a long slow recovery led by housing. I also suspect a major hiccup or buying opportunity after the election. Here's what all this might mean for BDCs.

So, why is all of this important to BDCs and what is a BDC?

BDC stands for business development company. What they do is to help develop companies in exchange for money or equity and often offer loans too. They are very selective about picking companies they think will make a serious profit because they get part of it via equity or money or whatever deal they make. If the company they invest in doesn't do well, neither do they. They are very much like a larger scale version of the guys on the TV show "Shark Tank," where they offer to invest in your company for a percentage of it and offer money and expertise. The vast majority of them are registered as regulated investment companies. This means that the SEC requires them to distribute 90% of taxable income in the form of dividends. So, most of the income must go to shareholders by law, which can be a good thing for the investor seeking income if they pick the right ones. There are many different types. Some specialize in technology companies, some energy companies, some leveraged buyouts, some recapitalization, etc. It is a very diversified group with many sporting dividends in the 6-10% or more range.

How have BDCs done during past economic expansions and contractions and over the last year?

During the last economic expansion, according to Nicholas Marshi who is a respected author on BDCs here on Seeking Alpha, there were only two BDCs out of around 20 that reduced their dividend from one quarter to the next between 2003 and 2007, and none eliminated their dividends altogether. That is incredibly impressive. Their track record is very strong in growing economies.

They will tank in economic contractions. They were one of the very worst sectors to be in during the early part of the recession. Since they loan to new companies, and new companies have problems in slowing economies, it was a huge disaster for most BDCs.

The last year has been an example of a relatively flat economy. During the last year, when the economy was fairly flat they did extremely well. Trailing total returns according to Morningstar showed the ten best performing BDCs with an average of a 52.81% return. They somehow didn't get in the mainstream dividend stock headlines much, which were more focused on Real Estate Investment trusts which had a great run too. Reference my article detailing this at

The BDC record is pretty clear. In a good economy they do well. In a bad economy, they do terribly. In a flat economy, like the one we have now, where banks are not lending money to startups, and they have lots of companies to choose to help, they have done well.

Recommendations based on the above

1) If you believe that the economy is on a slow steady recovery, and that the fiscal cliff will be a non-event, BDCs seem like a very good place to be. Banks are not lending much to the types of businesses BDCs support, and there will be more and more of them looking for help in a steady recovery. The BDCs will have their pick of the litter and should do very well. We should see many increasing their earnings and consequent dividends. This could last for several years. In the past expansion, most did well, so buying a basket of them could work well. Even the best ones could have some exposure to a new business they invest in that does poorly, so spreading the risk around makes sense in this category. UBS E-TRACS Wells Fargo Bus Dev Comp ETN is an ETN that contains 28 BDCs which are most or all that are known. The current distribution is around 7% (all from dividends) and the Morningstar Total Returns over the past year have been impressive at 34%. If you are a serious risk taker, there is also UBS E-TRACS 2x Wells Fargo Bus Dv Cm ETN which is the same fund double leveraged. That means you get about a 14% distribution. It also means that their total returns came in at at a whopping 75% over the last year. In a bad year, their losses would be doubled too, so it is very risky. There is some pad from the inflated dividend though.

2) If you believe that the economy is on a steady course with a hiccup around the time of the fiscal cliff, which is what I believe, the same stocks should still work well. You could consider investing some in BDCS now and maybe put some cash on hold to consider BDCS or even BDCL if it looks like the fiscal cliff storm has cleared and the economy is on track. I think BDCs will be on a multiple year run if the economy is stable.

3) If you believe the economy is headed down over the next few years, head for the hills. Don't put a penny in BDCs. They tanked in the past and they will do it again. They are all about new business expanding and they will do poorly in a bad economy when they contract.

Disclosure: I am long BDCL. 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.