The Fed has said it will finally hike interest rates this year. As rates rise, business development companies (BDCs) are a type of income stock that should perform especially well.
However, the uncertainties from inflation, omicron, and a waffling Federal Reserve will likely make for a bumpy ride over the next six-to-nine months.
The way to minimize the impact of these short-term challenges is to stick with the largest BDCs.
But before I list those, let’s talk about why BDCs will do well as interest rates rise…
Business development companies operate as pass-through entities under specific rules. The purpose of Congress was for BDCs to provide financing options for small and medium-sized corporations. A BDC makes loans to hold in its own portfolio. The rules allow a moderate amount of debt, and most BDCs are leveraged between one- and two-times equity. A BDC must pay at least 90% of net interest income as dividends to shareholders.
BDCs almost exclusively make adjustable-rate loans to their client companies. Combine that with their low levels of leverage, and you can see why, as interest rates increase, so does the net income generated by BDCs from their adjustable-rate loans. These stocks will be very attractive income investments in a rising interest rate environment.
About 50 BDCs trade on the U.S. stock exchanges. Almost half have market caps of less than $500 million, and only a dozen are valued at over $1 billion. Larger BDCs have distinct advantages over their smaller cousins. Here are three that come to mind:
- With a larger asset base over which to spread expenses, the larger market cap BDCs will have lower expenses as a percentage of assets. This allows more interest income to drop to the bottom line, increasing the cash available to pay dividends.
- Larger BDCs will borrow money at more attractive terms, meaning paying lower rates on their debt. As a result, the interest margin between what larger BDCs charge, minus what they pay in interest, will be greater. This factor also increases the net interest margin.
- Large BDCs can work with larger, more stable clients with greater assets and profits. A large BDC can also diversify the loan portfolio to more customers. A small BDC could be significantly hurt if a few clients got into financial trouble; however, there’s far less likelihood of that possibility for larger BDCs.
Using those factors to drive our investment research, here are the three largest publicly traded BDCs.
With a $10.0 billion market cap, Ares Capital (ARCC) comes in as the largest BDC. This stock currently yields 7.5%. Ares has paid a stable and slowly growing dividend since the bottom of the 2008-2009 bear market. The dividend has not been reduced since the summer of 2009.
Next up, with a $6.4 billion market valuation, is FS KKR Capital Corp (FSK). This BDC is the result of recent mergers between four different BDCs. With a current yield of 11%, FSK is the most speculative of these three BDCs. The high yield shows the market has priced in a dividend cut. Wait until after management’s 2021 earnings report and comments before committing any money to this stock.
Owl Rock Capital Corp (ORCC), with a $5.8 billion market cap, is the new BDC in town. Owl Rock came to market with a July 2019 IPO, and it has paid steady quarterly dividends since. Of the three BDCs discussed here, my research gives Owl Rock the best growth potential. The current yield is 8.4%.
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