Co-authored by Treading Softly.
The biggest mistake we can often make when it comes to investing or life, in general, is overcomplicating things. We tend to overcomplicate things because we may be knowledgeable in the subject and want to apply all we know to the situation, often making it much more difficult than necessary.
Recently, a friend was telling me about how he needed to cut out wood boards in a trapezoid shape to fit a space and make a bench. He spent over two hours figuring out the angles using Pythagoras’s theorem, among other mathematical means, to determine the exact angle he needed to cut each board so they fit perfectly. Yet, if he had just taken an extra moment to look around, he would have noticed that they had taken off a piece of carpet from that same area that made a perfect template. His wife simply traced the template, cut the wood, and it was ready in a matter of minutes.
When it comes to the market, we typically get in our own heads about how different sectors work, and we paint with too broad of a brush without understanding how everything works because we assume that we do.
Today, I want to return to the basics of one specific sector and then examine an ETF opportunity that gives you exposure to the entire sector.
Let’s dive in!
Touching on the Basics
BDCs (Business Development Companies) are often considered as companies that only do well when interest rates are climbing, or remain elevated. This is not true.
Built to revive the economy during brutal recessions, BDCs don’t work like banks with profits exclusively tied to net interest. By actively managing their portfolio and risk, BDCs generate a significant portion of their returns from realizations of portfolio investments. This puts them in a position to capture the rise in company valuations driven by market expectations for a sustained lower interest rate environment. These regulated entities typically take equity positions in their underlying portfolio companies, either as direct equity investments or as warrants or other equity kickers tied to debt arrangements. This places their participation in the low end of the capital structure, providing a source of enhanced returns at times of lower rates.
Moreover, BDC’s typical customers aren’t those who can walk into a bank and borrow at or near-prime rates. These are smaller firms, often dominating in a small niche, or distressed firms seeking capital to refocus and transform their business. Their typical borrowings come at SOFR + 6 or 7%, making the portfolio yield quite effective and significant even in a low-rate environment. When rates drop, there is increased borrowing and refinancing volume, and financial stress is reduced on borrowers, placing them in a better position to stay current on payments, effectively keeping BDC portfolio ratings at safer levels.
TriplePoint Venture Group (TPVG) is one such BDC that will benefit from lower interest rates, as it maintains a significant investment in warrants and equity positions in its borrowers. Not only does TPVG hold $45.8 million in direct equity at fair value, with 59 investments across 46 companies. The BDC also holds $32.7 million in warrants in 97 companies.
Altogether, we maintain strong exposure to BDCs during times of elevated rates and are happy to hold this income-friendly sector through the economic uncertainty ahead.
BDC Exposure Made Easy
VanEck BDC Income ETF (NYSEARCA:BIZD), yielding 11.3%, is an ETF providing diversified exposure to 26 public BDCs, with the holding percentage ordered by their market cap. The largest five public BDCs in the United States represent ~53% of the BIZD’s invested assets, representing stability and recession resistance through prudent underwriting, healthy balance sheets, and maximum exposure to senior secured loans. Notice BIZD’s ~21% exposure to the blue-chip and highly diversified Ares Capital Corporation (ARCC), indicating its preparedness for a recessionary economy. Source.
A $10,000 investment in BIZD in 2015 would have generated $7,651 in total dividends to date, at an annualized yield of 8.5%.
Since its IPO in 2013, BIZD has delivered growing dividends to shareholders, through rising and dropping interest rates, including near-zero rate conditions.
BIZD has been able to deliver this through prudent portfolio management across the spectrum of BDCs. Each BDC in the U.S. market is relatively unique in its composition and investment objectives, strategically benefitting from specific economic phenomena. In 2021, during the near-zero interest rate conditions, BIZD had a 12.6% exposure to ARCC. When the markets feared a recession in 2019, BIZD had approximately 19% exposure to ARCC. As rate cuts became aggressive in 2019, BIZD’s exposure to TPVG grew to 9% of net assets to seize the benefits of valuation gains and increased IPO activity.
Today, BIZD offers an above-average yield of 11.3%, presenting an attractive opportunity to collect generous dividends from this well-managed fund.
Conclusion
In ancient civilizations, it is not uncommon to build monuments or places of remembrance to draw back the memory of a specific event or principle. It can be important within our lives to have places or objects that we can touch and feel to bring back important memories. There is so much knowledge to gather and glean when it comes to the market, let alone every other aspect of our human experience, that developing these places of remembrance can help you stay on the right path when working towards a specific goal. BIZD is such a pillar that connects you to the entire BDC sector without having to try to game individual holdings. Personally, I like to hold the ETF itself for diversified access to BDCs and then supplement it with individual top-notch BDCs that I find attractive. This way, I can fine-tune my exposure to the entire sector after having gained it through the ETF itself.
BDCs provide much-needed liquidity to the economy by supporting companies that the banking sector overlooks or forgets. In collateral, they have access to their borrower’s IP and mission-critical assets and often have warrants and equity-kickers to sweeten the deal and participate in the prosperity of these borrowers. With the financial, strategic, and operational support of a quality BDC, middle-market companies can be significantly more successful. Likewise, maintaining exposure to BDCs in your portfolio can make your retirement exponentially better and more successful with a solid stream of dependable income.
Read the full article here