The investment landscape is generally not friendly to investors looking for quality yielding investments. With the 10-year Treasury yielding under 2% and investment grade debt offering not much more, it is really difficult to find quality yield.
Dividend stocks are great, but they have appreciated over time as well. Even high yield debt, otherwise known as junk, fell from grace last year, ending 2014 with a total return of just over 2%. Some of the better returns for 2014 were some of the traditionally “defensive” sectors like utility stocks and consumer staples stocks. Each is selling close to their all-time highs in valuation.
(More: Wilshire rolls out BDC index, setting the stage for investible versions)
There is, however, one asset class that is sporting a whopping yield of more than 9%, on average. I am referring to business development companies (BDCs). This lesser-known asset classes got swept up with the underperformance of high yield last year. BDCs are funds created under the Investment Company Act of 1940 and were created to provide capital funding to smaller companies. These are not credit-challenged companies, just smaller companies. Ever since the 2008-2009 financial crises, funding for small businesses has been throttled back by banks that are responding to greater oversight. BDCs have grown dramatically and now service the $5 million to $100 million businesses. In fact, BDCs have changed the landscape in business lending so much that it is likely that they have supplanted much of the regional and large banks' historical coverage of the group.
TREMENDOUS GROWTH
There are numerous BDCs in existence. Some are non-traded but the ones we are referring to are listed and trade on exchanges. The group has grown tremendously over the past five years as this type of business funding has exploded. The group's performance in 2014 lagged the general market after many years of superior performance. We feel that this group was affected by the general softness in the high yield market. We note that high yield debt is generally credit-challenged borrowers. BDCs lend to financially healthy borrowers, albeit small. The correlation to high yield does not make sense, in our opinion.
BDCs, as a group, have yields approaching 9%. Some have yields exceeding that level. The Wells Fargo BDC Index has returned 7.06% annually over the past 10 years. That compares with 8.01% annually for the S&P 500. The index currently has a dividend yield of 9.07%.
Many investors tend to be wary of high yielders, believing that the companies might cut their dividends.
We don't agree. In fact, we think BDCs are undervalued and potentially have upside to both their dividends and share price. Insiders agree, as they have been buying up shares of some larger BDCs in the market. Companies that have seen some substantial buying include Prospect Capital, Ares Capital, Main Street and Apollo. We doubt that insiders would be buying the shares if they expected a decrease in performance. We think insiders are telegraphing an opportunity to investors that these shares may be undervalued and have the potential to outperform in 2015.
USE CAUTION
Investors should use caution in buying any investment. BDCs have been a bit more volatile than other types of investments, but the rewards could very well be worth the ride. We think there is potential for a double-digit return in the group for 2015. They are one of our
best ideas for 2015.
Scott Colyer is CEO and CIO of Advisors Asset Management.
