Don’t Forget BDCs for Stable, High-Yield Income

Energy Investing

The Fed’s aggressive interest rate increases have been good for business development companies (BDCs). I have been recommending select BDC stocks all year and want to make clear that the investment potential remains very attractive.

Let me show you why – and give you one of my favorite BDCs…

Growing plant on rows of coin money for finance and banking concept

Congress passed the BDC rules to provide non-bank funding sources for small to medium-sized corporations. A BDC will primarily make client company loans and may also take on equity stakes. The rules governing BDCs limit the debt leverage allowed. These companies almost exclusively make variable-rate loans to client companies. As a result, when interest rates increase, a BDC’s net income also increases.

A BDC must pay shareholders at least 90% of its net interest income as dividends. These will be high-yield stocks, with many yielding near or over 10%.

There is one analysis mistake you will see with BDC analysis. Pundits will recommend specific BDCs because they trade at a discount to net asset (NAV) or book value. The opposite is true. You want to invest in BDCs that trade at a premium to NAV.

Because of the debt limit restrictions, for a BDC to grow, it must sometimes issue equity or shares to raise the equity base. A BDC that trades at a premium literally makes free money when it issues shares worth more than the current book value. A BDC trading at a discount will hurt book value with any equity issuance.

Also, the highest quality, best-managed BDCs typically trade at a premium-to-book value. Investors familiar with the BDC business type understand that management matters and will be fine with paying a premium for shares of the best companies in the sector.

Hercules Capital (HTGC), which focuses on venture lending, is one such BDC. They lend to entrepreneurs and their venture capital partners. This is a very specialized lending field, and Hercules has no peers.

HTGC pays a $0.40 quarterly dividend, giving a 9.8% current yield. The dividend is up from $0.33 per share paid two years ago. The company also pays out extra profits as supplemental dividends and has paid $0.08 per share for the last two quarters.

HTGC trades at a 48% premium to NAV.