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Investing in BDCs: Greater Yield, Greater Risk

An obscure investment option draws interest. In searching for greater yield, investors look down many avenues. One new (or at least relatively untraveled) avenue has garnered some buzz lately – investment in business development companies, or BDCs.

A BDC essentially functions as a subprime lender for a start-up or a financially struggling business. Big banks tend to reject the financing pleas of such companies – and that is where BDCs step in.

BDCs resemble real estate investment trusts (REITS) in one respect: by law, they have to convey at least 90% of their profits to shareholders. (Many BDCs pay out more than 90% of profits.) While they are regulated by the Investment Company Act of 1940, they are allowed to use more leverage than a garden-variety mutual fund – a 1:1 debt-to-equity ratio is permissible. There were just a handful of BDCs as recently as 2004, but there are about 30 of them now.

A bold alternative at the right time? BDCs are seemingly positioned to do well as our economy mends. They have the opportunity to borrow at dirt-cheap rates; BDCs charge firms that borrow from them above-market rates for the privilege.

If you do some homework, you can find a couple of ETNs/ETFs that hold a diversified range of BDCs in their portfolio. In the near future, there may be more such points of entry. Just as there are private REITs, there are also privately owned BDCs. Non-traded BDCs are sold through investment brokers.

Do BDCs have the potential for double-digit returns? Yes. Of course, so do myriad other investments.

The risk factor of BDCs cannot be understated. The risk-averse would be ill-suited to BDC investing, as this is a very volatile asset class greatly benefiting from a bull market. BDCs invest in junk-status companies. A company that turns to a BDC for financing may have a BBB- credit rating or no rating whatsoever.

If you have the stomach for alternative investments – and the wisdom to refrain from assigning more than a bit of your portfolio to them – then BDCs may be worth considering. Remember, though, that BDCs can prove illiquid and highly volatile, exposing investors to a substantial degree of risk. They may engage in leveraging and other speculative practices that could heighten this risk. In addition, some BDCs charge layer upon layer of (high) fees, and no viable secondary market exists for the non-traded variety. Remember that this article is just a brief introduction, not a recommendation of any kind; if you want to look into this asset class, proceed cautiously and with as much knowledge as possible.

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