BDC Yield Hogging

Mar 14 2014, 11:02am CDT | by

Income, income, income . . . as the Fed continues to keep interest rates low, achieving a tolerable yield remains the most perplexing challenge for many who seek income.

Adding to the challenge is the likelihood that rates will eventually rise and put pressure on prices of yield-oriented securities, including BDC (business development company) MCG Capital (MCGC).

That company, as well as another BDC I like, Gladstone Investment, offer stratospheric yields; 11.3% for MCGC and 9.0% for Gladstone. As grownups, we’ve all come to understand that when something looks so irresistible on the surface, there’s probably a catch. That’s definitely so here.

BDCs invest, usually through loans, in typically small privately-owned companies that fall between the cracks when it comes to the public capital markets and the volume-oriented increasingly-skittish commercial banks. So naturally, they bear default risk, which, considering the smaller number of deals in their portfolios, can look scarier than is the case for banks, or even high-yield bond funds (the securities purchased by the latter often are issued by companies similar to those to which BDCs lend).

But there’s an upside to this.

BDCs are able to give much more attention to individual deals than is the case with banks. And BDCs, dealing as they do with private transactions, can and do work with what traders in the public markets (such as the funds) would have to avoid as inside information. BDCs typically even get board seats or observation privileges enabling them to know a lot more about their debtors. BDCs typically do most of their deal in a limited number of industries (chemicals, machinery and electronics being important for GAIN).

Also, GAIN is more likely to provide capital to support acquisitions, and to take equity (usually preferred equity) stakes. Like all income investment, rising interest rates poses a challenge. But over time, the ability of enterprises that can increase incomes and distributions (as opposed to fixed-income securities) are better able to adjust.

Another advantage of high yield (for those who can bear the fundamental risks) is the opportunity to earn “interest on interest” at escalating rates.

Special Offer: For recommendations on where to invest in 2014 from Marc Gerstein and other experts download the new free report  12 Stocks To Buy For 2014 .

Excerpted from March issue of Forbes Low Priced Stock Report.

Marc Gerstein is editor of Forbes Low Priced Stock Report and research director at Portfolio123 and author of Screening the Market (Wiley, 2002).

Source: Forbes Business


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