Making Lemonade
The Federal Reserve’s quantitative easing policy, which ended on June 30, has helped to create an environment of very low interest rates which is making it increasingly difficult to generate income from securities. Any liquid, publicly traded security that offers a “spread” or yield has largely been snapped up by investors. In fact, according to Barron’s, on June 27 the dividend yield on the S&P 500 index was a mere 2.07% and the earnings yield for the index was 6.42%. There is good news and bad news in those figures.
Over the last 114 years, stocks, as measured by the Dow Jones Industrial Index, have been down for the year 40 times or 35% of the time. If the starting yield is 6.42% but one can only expect to receive it 65% of the time, then the true expectation is the yield times the probably of receiving it, or 4.17%, a yield remarkably close to the yield on a 30 year government bond. The good news is that companies are only paying out 32% of their earnings, thus investors can reasonably expect their yield to grow over time, unlike a government bond.
The current environment, with highly regulated banks, low interest rates and companies that are frugal with their dividend payments, potentially creates an opportunity in a sub-set of the market known as business development companies or BDCs.
BDCs were created by an Act of Congress in 1980 to encourage the flow of public equity capital into private businesses. BDCs are regulated by the Investment Company Act of 1940. They trade like public stocks or closed end mutual funds, but they hold investments in private companies. Frequently, BDCs provide financing to companies in the form of mezzanine loans. Mezzanine loans are similar to a second mortgage, in that they are subordinate to bank loans but have priority over the equity of the company.
Investors should be aware that BDCs have a long, colorful and controversial history. The structure of the BDC, if not run by a disciplined management team, may encourage unsound lending and investment practices. The act of valuing private companies can be extremely difficult and BDCs have fallen victim to the natural risks that come with investing in smaller, private companies which sometimes carry too much debt.
Investors can buy individual BDCs or for those wanting broader access to this private high yield strategy, there is an Exchange Traded Note (ETN) from UBS that tracks the Wells Fargo BDC Index of 26 underlying BDCs. ETNs have additional credit risk, in this case back to UBS, in addition to the risk of the underlying investments. As of April 26, the yield on this index was just over 7.6%.
Normally, reaching for yield is not a good idea. The peculiarities of the current environment with its heavy bank regulation, low interest rates, more conservative management teams and the inability of the public markets to originate and trade private company securities, may be combining to bring BDCs as an asset class into its own, much like REITs did for real estate and Master Limited Partnerships (MLPs) did for pipelines.
Allen Gillespie, CFA serves as the chief investment officer for Elliott Davis Investment Advisors and may be reached at agillespie@ediadvisors.com or 864-288-2849.