Saturday, August 3, 2013

Six issues to consider when investing in BDCs

US fixed income investors love their BDCs (see description). Given what's transpired in global fixed income markets, the overall BDC performance has been spectacular. Here is how BDCs did vs. HY bonds for example.

Source: Ycharts (blue = BDC index, orange = HY bond index)

People love these products because they carry unusually high dividends - often around 10%. Also a good portion of the portfolio assets are floating rate loans (LIBOR + spread), which makes them less vulnerable to rising rates. Furthermore some investors like BDCs because the loans held by these vehicles are often to middle market or even smaller firms, which makes investors feel as if they are circumventing banks. Buy a BDC and "become the bank". These are all great reasons to invest as long as one is aware of the risks. Here are some of them:

1. Keep in mind that BDCs operate a bit like hedge funds and charge similar fees (such as 1.5% management fee and 15% incentive fee).

2. The portfolio loans are indeed to middle market companies, which tend to carry higher rates. But a large portion of these loans is illiquid. That means when markets freeze up, the valuation could be in the hands of some "independent" valuation firm, which will "determine" the NAV.

3. Depending on the BDC, a good portion of your portfolio could be made up of mezzanine loans, which are not only illiquid, but also unsecured and subordinated. In addition, about 10% of many BDCs is in private equity securities.

4. The leverage of the companies that BDCs lend to could be fairly high, sometimes 5-6 times (debt to EBITDA).

5. BDC managers also leverage the whole portfolio, often lending $1.5 for every $1 of capital. Sometimes leverage is obtained using total return swaps, with potential risks of margin calls and forced sales.

6. As capital floods into middle market corporate space and lending becomes highly competitive, BDC managers will reach for yield in order to pay the same dividend. They will lend to increasingly risky credits.

That is why in a real credit crunch, BDC investors should be ready for a wild ride. Here is what BDCs did relative to flow HY bonds in late 2011, after the US debt got downgraded and people were concerned about Italy defaulting.

Source: Ycharts (blue = BDC index, orange = HY bond index)

So by all means, go ahead and invest in BDCs and enjoy the high dividend. Just be aware of what you own.
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