After Being Left for Dead, These High-Yield Stocks Look to Rally Again. Here's How to Play It.

When it comes to the market sub-segment devoted to investing in business development companies (BDCs) — and the VanEck BDC Income ETF (BIZD), which collects them into one tidy stock basket — there’s a situation going on. I’d say these stocks are again catching a bid. But not after a first-half shellacking. 

The chart below is a solid, optimistic chart to me. There’s some rediscovery of this beaten-down market area. But don’t kid yourself. As I’ll discuss below, there are some major overhangs here, which can appear again at any time. For now, the upward price trend is heartening. And the PPO recently crossing above the important zero line has been correlated with nice up moves in the past. 

BIZD’s stock holdings are top-heavy, particularly with Ares Capital (ARCC) at 14% of assets. That has as much to do with the sinking fortunes of many of the stocks below it, based on market fears of illiquidity and strong demand — not for the stocks, but from investors to get their money out of those firms’ private partnerships.

BIZD is still a $1.7 billion exchange-traded fund (ETF), so there remains a lot of interest in this set of stocks. And at 10x trailing earnings, it is much cheaper on paper than the broad stock market. Also note that the five-year beta is only 0.64, which tells me that until this recent wave of concerns, BIZD was a steady, high-income holding. It yields around 11% currently. 

What Are BDCs?

BDCs are different from your typical listed stocks. They operate as closed-end investment funds that provide direct private debt financing to small-to-mid-sized middle-market businesses. That industry’s recently publicized trend toward investors asking for capital back during regular quarterly liquidity opportunities naturally spooked investors. 

However, after being sold off over those concerns, as well as worries about potential middle-market defaults, BIZD is showing the most promising upside trend I’ve seen in a while. One reason could be that BDCs benefit from providing floating-rate loans in an environment where interest rates remain above historical lows, generating dividend yields often exceeding 9% to 10%. That’s nearly three times the yield of even the upper end of S&P 500 single-stock yields. BDCs borrow capital at fixed rates or via long-term credit facilities and lend it out to private middle-market companies at floating rates linked to benchmark short-term interest rates. So, BDCs can capture a yield spread, distributing nearly all of their taxable income to shareholders to maintain tax-exempt status at the corporate level.

And, as CEOs of these companies are quick to point out, the majority of modern BDC portfolios consist of first-lien senior secured debt, positioning them at the top of the capital structure if a portfolio company defaults or restructures. That makes them technically a better risk than common stocks of the same companies. 

Furthermore, with private equity sponsors stepping in to support portfolio companies and underwriting standards remaining strict, the fear of widespread middle-market defaults has eased, allowing BIZD’s underlying NAVs to recover.

What Are the Risks of BIZD ETF?

One major issue is credit quality degradation. That is, if economic growth slows significantly, weaker middle-market borrowers may struggle to service floating-rate debt, driving up non-accrual loans. There’s also prepayment risk. Rapid central bank rate cuts reduce the interest income generated by floating-rate loan portfolios, narrowing BDC dividend coverage ratios.

To me, BIZD is firmly in the camp of high-risk, high-return potential. It sits in the middle of a $12 to $15 price range. But breaking even on price here means getting that fat double-digit yield as your return. That’s a kicker most equity investors don’t get a chance to consider. 

Rob Isbitts is a semi-retired CIO, former fiduciary investment advisor, and Barchart columnist. Check out his other work at ETFYourself.com (featuring the Fresh Charts weekly trading post), and ROAR.PiTrade.com, helping investors to better-manage their own portfolios.