by Bryan Perry
June 11, 2024
Last Friday, the U.S. Treasury market took it on the chin following the release of the May jobs report data showing that the economy added 272,000 jobs, versus a consensus expectation of 185,000.
The market’s response was an immediate jump in yields. The yield on the 10-year Treasury note settled 15 basis-points higher on the day and eight basis-points lower on the week, to 4.43%. The two-year note yield jumped 15 basis-points, which left it two basis-points lower for the week, ending at 4.87%.
The message to investors is pretty clear: Don’t expect a rate cut in July or maybe even September. The latest CME FedWatch Tool shows a nearly 92% probability of the Fed holding the Fed funds rate at 5.25%-5.50% at the July 31 Federal Open Market Committee (FOMC) meeting. This is up from a 65% probability just one month ago, thereby underscoring the Fed’s “higher for longer” narrative.
The upshot from the Friday jobs report is that good news for the labor market is typically good news for the economy and organic growth for small to medium-sized businesses. But accessing capital to expand one’s business is more costly in today’s lending rate environment, which is a headwind to borrowers, but a major tailwind to lenders, providing easy access to capital. With regional and community banks saddled with billions of dollars in low-yield Treasuries that are trading at deep discounts to par value, plus too much exposure to corporate office properties with high vacancy rates, and more stringent lending standards brought on the by the regional bank collapse of 2023, companies are turning to Business Development Companies (BDCs) to meet their capital needs for borrowing at today’s lofty rates.
For those unfamiliar with the BDC structure, they are a type of closed-end fund that invests in small-to-medium-sized companies, helping firms grow in the initial stages of their development. Many BDCs are public companies whose shares trade on the major stock exchanges.
In light of what Louis Navellier has said about Private Credit Funds, it’s important to note that there is a clear distinction between BDCs and Private Credit Funds that deploy up to 200% leverage to finance a great deal of M&A activity. A majority of Private Credit Funds require investors to hold their money in the funds for 5-10 years, making for a non-liquid investment. The total U.S. fixed income market is valued at around $55 trillion with only about $2 trillion dedicated to the private credit market, of which roughly $545 billion is in dry powder looking for deals; so while there are isolated situations where too much leverage can create risk, such exposure relative to the entire fixed income market I believe is not that high.
The exchange-traded BDC market is currently valued at $156 billion, spread among 79 BDCs with the ability to buy and sell shares. The average BDC has a debt-to-equity ratio of 1.1%, which reflects almost no use of leverage. Like Private Credit Funds, BDCs finance non-listed companies that include liquidity risk. Hence, the higher yield is intended to compensate investors for the risk of an adverse liquidity event.
BDCs are also similar to REITs in that they are Regulated Investment Companies (RICs) and, as such, are required to pass through at least 90% of their earned income to shareholders to avoid paying corporate income taxes. The BDC must be a domestic company and invest at least 70% of its assets in private or public U.S. firms with market values of less than $250 million. There are a few ways BDCs make capital available to private businesses – through the purchase of equity in the companies, issuing a convertible bond, structuring loans or some combination of these. In today’s market, BDCs are heavily weighted in floating-rate loans within their portfolios that adjust to higher rates when short-term rates rise.
The 11 rate hikes the Fed has made from 2022 to 2023 made the BDC business very lucrative, with the top BDC portfolio compositions invested at least 90% in floating rate debt issues tied to Fed Funds, or the Secured Overnight Financing Rate (SOFR), which replaced the London Interbank Offered Rate (LIBOR) in 2023. As of June 6, the SOFR rate stands at 5.33%. Loans issued by BDCs will be crafted as SOFR plus 6%, for example, making the cost of interest to the borrower over 11%.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
It is not uncommon for lending rates from BDCs to exceed 13% when one considers they are investing primarily in private illiquid companies. Therefore, investors are on the receiving end of juicy dividend yields range from 8% to 14% annually. The number of portfolio companies invested in by BDCs varies from under 20 to over 100, depending on the BDC’s strategy. One way to diversify the risk for investing in BDCs is to consider an ETF such as the Van Eck BDC Income ETF (BIZD), which owns several of the biggest BDCs by assets under management (AUM).
The 30-day SEC yield for BIZD is 10.03%, and it pays out a quarterly dividend. Several BDCs have implemented monthly payouts – a highly attractive feature to income investors. Because of the squeeze on lending by banks, the demand for capital by private businesses and the Fed’s tighter monetary policy that is showing fresh signs of staying at current higher levels, business conditions for BDCs are downright bullish. The chart of BIZD is similar to that of its holdings – up and to the right.
All content above represents the opinion of Bryan Perry of Navellier & Associates, Inc.
Also In This Issue
A Look Ahead by Louis Navellier
Overseas Rate Cuts Could Help Lower U.S. Yields This Summer
Income Mail by Bryan Perry
Non-Leveraged High Yield Asset Class Pays Double-Digit Yields
Growth Mail by Gary Alexander
High Tech Stocks Can Create (or Crater) Fortunes
Global Mail by Ivan Martchev
Fresh All Time Highs, Now What?
Sector Spotlight by Jason Bodner
Why Do You Invest? To Hoard Wealth, or Spend It?
View Full Archive
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Bryan Perry
SENIOR DIRECTOR
Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.
Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry
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