With 77 million baby boomers now in or preparing for retirement, many Americans' investment portfolios are undergoing a significant shift. In the face of longer life expectancies, they are seeking to increase investment income and protect their nest eggs in the years to come — no small feat, given what the market has to offer.
Today, traditional fixed-income holdings, such as bond funds, may not provide enough meaningful income on their own. Historically low interest rates have limited the yields available to investors. The imminent rise in short-term rates repeatedly signaled by the Federal Reserve may help. However, rate increases may diminish the value of fixed-rate holdings in the near term. Additionally, persistent market volatility has resulted in significant swings in the performance of fixed-income assets in portfolios.
These forces have led investors to seek out more stable, noncorrelated investment strategies that can potentially produce healthier streams of income. What are their options? A recent Natixis study revealed that nearly 70% of investors feel that a traditional stock and bond portfolio is no longer sufficient when attempting to pursue returns and preserve capital.
So investors and their financial advisers are increasingly turning to alternative investments for income and diversification. According to a Morningstar/Barron's Alternative Investment Study, 73% of advisers cite low correlation as a top reason for choosing alternatives.
BDC AS INCOME ALTERNATIVE
Business development companies, or BDCs, have drawn attention among income-producing alternatives. Growth in the BDC industry in recent years has been remarkable. Today, there are more than 60 BDCs (traded and nontraded) managing over $65 billion in assets. Despite this, relatively few investors know about them or understand their benefits.
A BDC is a pooled investment fund, similar to a mutual fund, that holds a portfolio of assets. However, instead of investing primarily in publicly traded equities or other securities of public companies, BDCs can invest in the debt and/or equity of private U.S. companies.
A BDC provides financing, whether through loans or ownership, to small- and medium-size businesses. Nearly 200,000 businesses comprise the U.S. middle market, which translates to one-third of America's private sector GDP and more than 47 million jobs. Because these businesses play an indispensable role in driving our economy, financing their operations is critical. However, increased banking regulations have made it less economical for banks to lend to private businesses, shrinking the pool of traditional lenders.
Congress created the BDC in 1980 through an amendment to the Investment Company Act of 1940 to help facilitate the flow of capital to private businesses. Amid the pullback in middle-market lending over recent years, BDCs have grown in number and size to fill the void for private U.S. companies that need capital to build and operate their businesses.
INVESTORS' OPPORTUNITY
Investing in private companies had once been limited to large institutional investors such as endowments or pension funds. Today, BDCs allow individuals to gain access to similar strategies at low investment minimums while enjoying several other potential benefits.
• They can earn better yields. BDCs, which pass through at least 90% of their investment company taxable income to shareholders, have historically generated a higher level of current income than many other traditional fixed-income investments. As of June 19, an index of publicly traded BDCs had an average yield of more than 8%.
• BDCs offer transparency. Like mutual funds, these funds disclose both the fair value and some of the most significant financial terms of every investment in their portfolio on a quarterly basis.
• The BDC structure places strict limits on the amount of debt it can take on and requires a minimum level of diversification.
• Some BDCs hold floating-rate loans, often with seniority in the capital structure. These loans can protect against interest rate risks. They can also limit credit losses in the event of a default.
Today's environment calls for those preparing for retirement to enhance the diversification within their portfolios. Fortunately, investors now have more alternatives like BDCs that behave differently than traditional investments and may help investors achieve attractive levels of current income, improve diversification and lessen portfolio volatility.
Michael Kelly is the chief investment officer of Franklin Square Capital Partners.
