Opportunities in Business Development Companies
FRAN RODILOSSO: I am Fran Rodilosso, head of fixed-income ETF portfolio management at Van Eck, and I am speaking today with Chris Testa, an equity research analyst specializing in business development companies and registered investment companies at National Securities Corporation. Chris, how should an investor look at BDCs it in their portfolio? What are some of the opportunities, but also the risks?
TESTA: I would say the opportunities are twofold. For many investors, when they look at where a BDC may potentially fit, they are strictly looking at where they would put a yield-oriented vehicle in their portfolio. But many of these investors are not necessarily looking at duration risk. If you were to go out and buy a high-yield bond, or even just take a loan itself, that has significant duration risk. The vast majority of BDCs have roughly more than 70% of their loan portfolio in floating-rate debt investments. All else held equal, the majority of the sector will benefit from rising rates. Now, you get what you pay for. There is a reason why the average yield in the BDC sector is roughly 10% [based on NSC research] because making corporate loans that are 6 to 5.5 times leveraged, compared to banks making a two-times leveraged revolver, does entail significantly more risk.
RODILOSSO: That makes sense. Other than lending to middle-market borrowers -- what else might be in a BDC's portfolio?
TESTA: BDCs have to have 70% of their assets in what's called "qualifying investments." Essentially, those are loans that are given to small- and middle-market enterprises. BDCs are not so much permitted to invest in areas, such as real estate, online lending, or collateralized loan obligations, although they are holding essentially the same thing as BDCs, but 9, 10-to-1 leverage. So they could fill that 30% basket up, but, generally, that is what goes into that aside from the traditional BDC loans. Some barely use this, some use it up to 5%, and a couple of BDCs use it all the way up to 30%.
RODILOSSO: Do we have any statistics on default rates of BDCs themselves, but maybe more importantly, their underlying portfolios? And we mentioned the amount of leverage that these borrowers tend to have.
TESTA: Great question. For BDCs, the trailing 12-month default rate in leveraged loans has been roughly 2% [as of October 2016], or even a little bit less. Now, this compares to a much higher default rate in high-yield bonds. The middle-market default rate peaked in '08, '09, at roughly 12%, depending on whose measures you look at. The other thing that's worth noting is that, over roughly 18 years or so of data, the average recovery rate on U.S. senior secured leveraged loans is roughly 75%, whereas for bonds, it's traditionally 40%.
RODILOSSO: My next question is about the discounts and premiums in the market, when we get into owning the equities of these BDCs, which effectively trade like closed-end funds. So they may trade at premium or discount to net asset value. Does that premium or discount sometimes reflect the valuation methods? Is there enough transparency to the market?
TESTA: I would say there is enough transparency. When you look at the discounts and premiums -- so, firstly, you have most of the internally managed BDCs trade significantly higher. This has nothing to do with the valuation methodology, but it's just because they're internal. But looking at the space as a whole, if you look at the ones that are heavily discounted, there are usually two things. One is that people do not trust the NAV as much, maybe because they are not marking their book the way that investors believe that they should be marking it. The second reason as to why they might be trading at discounts is usually because of high non-accruals, underperformance, and like we had discussed before, that 30% basket loaded with Collateralized Loan Obligations, Collateralized Loan Obligations equity, online loans, real estate – investors don't like to see that. They want a business development company. Those factors together are usually what creates significant discounts. Now, if you look at the BDCs trading at premiums, they're usually boring in the sense that they are just making middle-market loans. They're doing what they should be doing. They have prudent capital management. They have lower fee structures. And they have a track record of consistently marking the book as it should, and usually a stable-to-increasing NAV per share.
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The views and opinions expressed are those of the speaker and are current as of the video’s posting date. Video commentaries are general in nature and should not be construed as investment advice. Opinions are subject to change with market conditions. Mr. Christopher Testa and National Securities Corporation are not related to Van Eck Securities Corporation or its affiliated entities. We believe this information to be reliable, but do not warrant its accuracy or completeness. The views and strategies may not be suitable for all investors. The material is for informational purposes only and is not intended to provide, and should not be relied on for accounting, legal, or tax advice. Any forecasts contained herein are for illustrative purposes only and are not to be relied on as advice or interpreted as a recommendation. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions.
Please note that Van Eck Securities Corporation offers investment products that invest in the asset class(es) in this video. There are risks in investing in BDCs. Business Development Companies (BDC) invest in private companies and thinly traded securities of public companies, including debt instruments of such companies. Generally, little public information exists for private and thinly traded companies and there is a risk that investors may not be able to make fully informed investment decisions. Less mature and smaller private companies involve greater risk than well-established and larger publicly-traded companies. Investing in debt involves risk that the issuer may default on its payments or declare bankruptcy and debt may not be rated by a credit rating agency. Many debt investments in which a BDC may invest will not be rated by a credit rating agency and will be below investment grade quality. These investments have predominantly speculative characteristics with respect to an issuer's capacity to make payments of interest and principal. BDCs may not generate income at all times. Additionally, limitations on asset mix and leverage may prohibit the way that BDCs raise capital.
A BDC’s incentive fee may be very high, vary from year to year and be payable even if the value of the BDC’s portfolio declines in a given time period. Incentive fees may create an incentive for a BDC’s manager to make investments that are risky or more speculative than would be the case in the absence of such compensation arrangements, and may also encourage the BDC’s manager to use leverage to increase the return on the BDC’s investments. The use of leverage by BDCs magnifies gains and losses on amounts invested and increases the risks associated with investing in BDCs. A BDC may make investments with a larger amount of risk of volatility and loss of principal than other investment options and may also be highly speculative and aggressive.
Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. An investor should consider the investment objective, risks, charges and expenses of the Fund carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 800.826.2333 or visit vaneck.com/etfs. Please read the prospectus and summary prospectus carefully before investing.
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MEANING OF RATINGS:
BUY: the stock is likely to generate a total return of at least 10% over the next 12 months and should outperform relative to the industry.
NEUTRAL: the stock is likely to perform in-line with the industry over the next 12 months.
SELL: the stock is likely to underperform (from a total return perspective) relative to the industry over the next 12 months.
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