Interesting Asset Class Offers Dual Benefits

Yes, 10-year Treasury yields recently declined and those in the transitory inflation camp are increasingly convinced the Federal Reserve won't shorten its timeline for interest rate increases.

Those scenarios, should they prove persistent and accurate, are positives. However, as advisors well know, failure to prepare is preparing to fail. That's particularly true when it comes to the delicate balancing act of buffering portfolios against rising interest rates while generating income.

Often times that means considering some unique asset classes beyond bonds and equities. One asset class that can thrive when rates rise is business development companies (BDCs). For those not familiar with BDCs, these are companies that loan capital to smaller and mid-sized firms, often private companies, that have below investment-grade credit ratings that often struggle to procure loans from traditional banks.

Since they are lenders and often take stakes in the companies they lend to, BDCs are able to deliver superlative levels of income. For example, the VanEck Vectors BDC Income ETF (NYSEARCA:BIZD), the dominant exchange traded fund addressing the asset class, sports a 30-day SEC yield of 8.13%.

BDCs: Rising Rates Protection

Historically, high dividend sectors, such as real estate and utilities, are inversely correlated to rising rates, but the opposite is true of BDCs. Actually, BDCs' relationship to rates is similar to that of banks.

“BDCs generate income based on their net interest margins, or the difference between interest income from portfolio investments and interest expense on borrowings/debt, and are well positioned to succeed in a rising interest rate environment with over 80% of loans, on average, in BDC portfolios featuring a floating rate,” according to VanEck research.

Due to the floating rate component, BDCs are ideally positioned to benefit from rising rates. Pair that with the spate of low fixed rate issued by BDCs over the past 12 months, and the asset class becomes all the more potent.

“This means that as base interest rates increase, BDCs will likely see higher net interest margins and increased annual net income. As an example, the below table shows the projected impact of increases in base interest rates on interest income and expense for Ares Capital Corp., one of the largest publically traded BDCs,” adds VanEck.

Underscoring the positive correlation of BDCs to rising interest rates, a Federal Reserve rate hike of 100 basis points would boost Ares' net interest income by $25 million and net income by $10 million, Three hundred basis points tacked on to the Fed's benchmark rate would add $261 million to the firm's interest income, according to VanEck data.

Rebounding Economy Idea, Too

Something smart advisors impart upon clients is that there's always a trade-off when reaching for income and it usually means some form of elevated risk. With BDCs, the risk is that the asset is, as 2020 proved, vulnerable in weak economies because recessions can hamper loan repayment.

For example, BIZD lost 6.8% on annualized volatility of 52.2% last year amid elevated fears of loans with overdue interest payments. With the economy improving, so is that situation.

“Additionally, and perhaps even more importantly, the portion of non-accrual status loans, or loans with overdue interest payments, in BDC portfolios have been falling over the last few quarters,” notes VanEck.

That's a sign BDCs are worth examining even if rates don't rise anytime soon.

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