BDCs can be an excellent source of high income, but they are not the holy grail that some investors believe. The group faces mounting pressures as well as categorical drawbacks (that are often overlooked). In this report, we share updated data on over 35 big-yield BDCs, review our concerns with the group, highlight 3 top BDCs that standout as attractive, and then conclude with a few alternative high-income opportunities that are currently worth considering too.
BDC Overview: No Corporate Tax, But Non-Qualified Dividends
BDCs are an interesting group considering they can avoid paying taxes at the corporate level if they pay out substantially all of their income as dividends (i.e. therefore the big dividends many income-focused investors love). No corporate taxes is a government incentive established to incentive BDCs to provide financing (mostly loans) to smaller (middle market) businesses. However, it’s noteworthy that BDC dividends are generally non-qualified (qualified dividends are taxed at a lower rate, BDC dividends are generally taxed at the higher ordinary income tax rate).
Investors often overlook the higher tax rate on BDC dividends, but they shouldn’t. For example, you may consider holding your BDCs in a traditional IRA instead of a taxable account (to help reduce the tax impacts). And if you do own BDCs in a taxable account, don’t forget you’re generally going to get taxed at your higher ordinary income tax rate.
The Space Is Getting Crowded
Another factor BDC investors should take into consideration is increasing competition for investment opportunities among growing BDCs (including non-traded BDCs). According to a report from Fitch Ratings, BDCs are seeing credit deterioration and pressure on deal terms and speads. Specifically:
“The growth of perpetual non-traded BDCs and solid fundraising from established firms will continue to impact underwriting dynamics. Deal volume was relatively muted in 2023 given the wide bid-ask spread between buyers and sellers and limited refinancing activity in the high interest rate environment, but deal activity is expected to improve in 2024, and several BDC managers have pointed to improving pipelines.”
We can see in our earlier BDC table that plenty of BDCs have posted fairly healthy total returns (i.e. price appreciation plus dividends as if they were reinvested) over the last 5 and 10 years. However, the space is changing as competition rises, banks continue to shed risks (for regulatory purposes) and BDCs are taking on more risk.
Valuations are Not Low
Further still, BDC valuations are not particularly low, especially considering the risks. For example, you can see in our earlier table that price-to-book values sit much closer to the top of the 5-year range than to the bottom (an indication that BDC prices are not currently particularly low as compared to their values). Especially considering the potentially elevated risks for non-accruals (i.e. loan recipients not being able to correctly pay back their loans).
Non-Accrual Risk
According to Fitch Ratings:
“Non-accruals and defaults are not rising to the degree initially expected by BDCs when interest rates began to rise, with middle-market loans generally performing well YTD. However, the continuation of elevated interest rates combined with a more challenging economic backdrop should weaken asset quality metrics as more portfolio companies face interest coverage of less than 1.0x. Non-accrual investments remain at unsustainable lows, averaging 2.2% of rated BDCs’ debt investments at cost and 1.2% at fair value at 3Q23.”
Fitch believes the negative impacts of higher interest rates will play out through higher non-accruals, especially against a challenging macroeconomic backdrop. Investors beware.
3 BDCs Worth Considering
Ares Capital (ARCC) is the largest publicly traded BDC and frequently an investor favorite. Certainly, Ares has wide operational and financial resources and relationships enabling it to source deals not available to other BDCs. However it has risks too. For example, ARCC typically has a higher level of subordinated and non-first-lien investments than other BDCs, and as you can see in our earlier table—short interest (i.e. investors betting against the shares) is higher for ARCC than for many of its peers.
Considering Ares strong 5-year and 10-year returns, its somewhat “rich” price-to-book value, and the economic backdrop, investors may want to review how much Ares they own (i.e. do you have too many of your investment eggs in the Ares basket?). To be clear, we think Ares is an attractive big-yield investment, but this does not appear to be the best time in the market cycle to be over-allocating investment dollars to Ares.
Saratoga Investment Corp (SAR) is a relatively smaller BDC, and it may currently be a bit of a “value trap.” Specifically, the price-to-book may appear temptingly low, but their are reasons why it is low (i.e. risks). We recently wrote about Saratoga in detail here, and considering the less-transparent financing risks, we are not investing in Saratoga at this time (despite its temptingly low price-to-book value).
Hercules Capital (HGTC) is another popular big-yield BDC that has performed well, however it is exposed to unique risks related to its growth-company focus. In particular, growth companies have rebounded extremely hard after the pandemic bubble burst. But HTGC seems particularly risky considering the party for growth companies could end if the Fed doesn’t cut rates later this year as is widely expected. Hercules has among the highest short interest (4.2%) and one of the highest price-to-book valuations (also near the top of its own historical range). Hercules is an attractive BDC, but this may not be the best point in the market cycle to be overexposed to Hercules.
Main Street Capital (MAIN) is another popular big-yield BDC, but for different reasons. Main Street is internally owned and managed (something may investors like) and it pays dividends monthly (another characteristic a lot of income investors appreciate). Main Street invests is more “off Wall Street” value industries, perhaps an attractive contrarian quality in the current market environment, however it also invests in “lower” middle market (smaller) companies, also a risk factor). Ares typically has a very high price-to-book value relative to peers, and it currently has a very low debt-to-equity ratio (an encouraging characteristic during bumpy roads).
Conclusion:
We currently own shares of Ares Capital (ARCC), Oaktree (OCSL) and Main Street (MAIN) in our High Income NOW Portfolio, however we recently reduced our position size in all three because we are less comfortable with BDCs at this point in the market cycle. Instead, we have a large allocation to closed end funds because that group currently offers much more compelling high-income opportunities in our opinion. For what it’s worth, we’re also staying far away from most REITs (despite that fact that they have been performing terribly and some contrarian investors want to try to catch falling knives at this point in the market cycle).
If you are a high-income-focused investor, the market continues to offer select attractive opportunities, but be smart about it. Don’t go dumping too large of a percentage of your nest egg into one or two securities or one or two types of securities. Disciplined goal-focused long-term investing has been a successful strategy throughout history, and we believe it will be this time too.