Advisors consider BDCs as Fed rate cuts loom

With Federal Reserve rate cuts supposedly on the way, should yield-seeking advisors seek out high-yielding business development companies (BDCs)?

BDCs blend attributes of publicly traded companies and closed-end funds, giving holders exposure to high-yielding, private equity-like investments. As a result of those higher yields, however, BDCs also tend to carry additional risk and can sell off quickly. BDCs primarily invest in the debt of small to midsize domestic companies, a strategy that has become all the rage of late as more advisors seek exposure to private credit.

Barings BDC (Ticker: BBDC), for example, invests in debt for middle market companies and currently yields 10.3 percent. BBDC is up 12.7 percent year-to-date.

Matt Freund, president of Barings BDC, says one of the chief benefits of publicly traded BDCs is their “accessibility,” especially now that private credit is in such high demand.

“There's often a trade-off between the liquidity of a BDC and the associated NAV volatility. And so as we think about different structures and different products, the most liquid is going to be a publicly traded BDC,” said Freund.

Freund says the prospective reduction in interest rates through Fed rate cuts is a “double-edged sword” for the BDC asset class.

“It's true that the underlying loans are floating rate securities so a reduction in interest rates will produce lower interest income off of the portfolio. At the same time, we believe that there are two positive benefits to a reduction in interest rates. One is going to be a catalytic event that drives more transaction activity. We do believe that more LBO activity will drive additional opportunities for deployment,” said Freund.

“The other reality is that a lot of the BDC liabilities are in some instances floating rate,” said Freund. “And so as BDCs have floating rate liabilities, a reduction in interest rates could actually have some interest savings from a BDC investment vehicle perspective.”

Stephen Kolano, chief investment officer at Integrated Partners, says the bigger focus as it relates to BDCs is less on near term rate cuts and more on the level of interest rates longer term in relation to refinance schedules and default levels.

“The market may not be currently focused on this outlook but should certainly be thinking about the longer term in relation to BDC’s," said Kolano.

Eric Amzalag, owner of Peak Financial Planning, meanwhile, is not currently recommending BDCs to clients. Despite rate cuts being on the horizon, he feels the effects of higher interest rates is still yet to be fully felt by smaller cap companies including businesses owned by BDCs.

“The small rate cuts on the horizon actually won't have a significant effect in mitigating the risk those companies are facing,” said Amzalag. “It's helpful to remember that high yielding BDCs are trying to attract capital by offering high yields - the higher the yield, the higher the risk of the underlying holding. I recommend investors not get lured in by the high yields and remember what the strategic purpose is of those high yields.”

Daniel Lash, certified financial planner with VLP Financial Advisors, agrees that investors need to remember that high yield also comes with greater risk. He adds that they should also be aware of the steep leverage inherent in many BDCs.

“Those BDCs with greater leverage will have greater risk, but if an investor is looking to buy investments which are more equity based and with interest rate sensitivity, rather than fixed income, BDCs may be a good place to anticipate interest rates lowering in the coming months potentially,” said Lash. “I would recommend BDC investments to make up a smaller percentage of a client’s portfolio due to the overall risk of these investments.”