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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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IMPORTANT DISCLOSURE


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.


No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of Van Eck Securities Corporation. © Van Eck Securities Corporation.


Van Eck Securities Corporation, Distributor
666 Third Avenue, New York, NY 10017


National Securities Corporation
410 Park Avenue, 14th Floor, New York, NY 10022

REG AC ANALYST CERTIFICATION


The research analyst named on this report, Christopher Testa, certifies the following: (1) that all of the views expressed in this research report accurately reflect his personal views about any and all of the subject securities or issuers; and (2) that no part of his compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by him in this research report.


This publication does not constitute and should not be construed as an offer or the solicitation of any transaction to buy or sell any securities or any instruments or any derivatives of the securities mentioned herein, or to participate in any particular trading strategies. Although the information contained herein has been obtained from recognized services, and sources believed to be reliable, its accuracy or completeness cannot be guaranteed. Opinions, estimates or projections expressed in this report may make assumptions regarding economic, industry, company and political considerations, and constitute current opinions, at the time of issuance, which are subject to change without notice.


This report is being furnished for informational purposes only, and on the condition that it will not form a primary basis for any investment decision. Any recommendation(s) contained in this report is/are not intended to be, nor should it / they construed or inferred to be, investment advice, as such investments may not be suitable for all investors. When preparing this report, no consideration to one’s investment objectives, risk tolerance and other individual factors was given; as such, as with all investments, purchase or sale of any securities mentioned herein may not be suitable for all investors. By virtue of this publication, neither the Firm nor any of its employees shall be responsible for any investment decisions. Before committing funds to ANY investment, an investor should seek professional advice. Any information relating to the tax status of financial instruments discussed herein is not intended to provide tax advice, or to be used by anyone to provide tax advice. Investors are urged to consult an independent tax professional for advice concerning their particular circumstances. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, either expressed or implied, is made regarding future performance.


National Securities Corporation (NSC) and its affiliated companies, shareholders, officers, directors and / or employees (including persons involved with the preparation or issuance of this report) may, from time to time, have long or short positions in, and buy or sell the securities or derivatives (including options) thereof, of the companies mentioned herein. One or more directors, officers, and / or employees of NSC and its affiliated companies, or independent contractors affiliated with NSC may be a director of the issuer of the securities mentioned herein. NSC and / or its affiliated companies may have managed or co-managed a public offering of, or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this report within the last three (3) years, or may, from time to time, perform investment banking or other services for, or solicit investment banking business from any company mentioned in this report.


This research may be distributed by affiliated entities of National Securities Corporation (NSC). Affiliated entities of NSC may include, but are not limited to, vFinance Investments, Inc., National Asset Management and other subsidiaries of our parent company, National Holdings Corporation.


The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce if any, may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Furthermore, NSC may follow emerging growth companies whose securities typically involve a higher degree of risk and more volatility than the securities of more established companies. This report does not take into account the particular investment objectives, financial situation or needs of individual investors. Before acting on any advice or recommendation in this material, the investor should exercise independent judgment as to whether it is suitable in light of his/her particular circumstances and, if necessary, seek professional advice. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance.


Additional information relative to securities, other financial products, or issuers discussed in this report is available upon request. Neither this entire report, nor any part thereof, may be reproduced, copied or duplicated in any form or by any means without the prior written consent of National Securities Corporation. All rights reserved. NSC is a member of both the Financial Industry Regulatory Authority (FINRA) and the Securities Investors Protection Corporation (SIPC).


For disclosures inquiries, please call us at 1-800-417-8000 and ask for your NSC representative, or write us at National Securities Corporation, Attn. Richard Cohen - Research Department, 410 Park Avenue, 14th Floor, New York, NY 10022, or visit our website at www.nationalsecurities.com.


Estimates Disclosures Legend


Relevant Disclosures:

  1. National Securities (NSC) is a market-maker in the securities of the subject company
  2. In the past twelve (12) month period, NSC and / or its affiliates have received compensation for investment banking for services from the subject company
  3. In the past twelve (12) month period, NSC and / or its affiliates have received compensation from the subject company for services other than those related to investment banking
  4. In the past twelve (12) month period, NSC was a manager or a co-manager of a public offering of one or more of the securities of the issuer
  5. In the past twelve (12) month period, NSC was a member of the selling group of a public offering of the security (ies) of the issuer
  6. One or more directors, officers, and / or employees of NSC and / or its affiliated companies is / are a director (s) of the issuer of the security which is the subject of this report
  7. NSC and / or its affiliates expects to receive or intends to seek compensation for investment banking services from the subject company at some point during the next three (3) months
  8. A Estimates analyst or a member of his / her household has a financial interest in the securities of the subject company as follows: a) long common stock; b) short common stock; c) long calls; d) short calls; e) long puts; f) short puts; g) long rights; h) short rights; i) long warrants; j) short warrants; k) long futures; l) short futures; m) long preferred stock; n) short preferred stock
  9. As of the end of the month immediately preceding the date of publication of this report or the end of the prior month if the publication is within ten (10) days following the end of the month, NSC and / or its affiliates beneficially owned one percent (1%) or more of any class of common equity securities of the subject company.
  10. Please see below for other relevant disclosures

 

Shares of this security may be sold to residents of all 50 states, Puerto Rico, Guam, the US Virgin Islands and the District of Columbia.


*Investment banking services provided in the previous 12 months. Ratings are current at the time of issuance, however, they are subject to change without notice and NSC is under no obligation to update this video.


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.


NR: Not Rated


SP: Suspended