In recent news, Business Development Company (BDC) Ares Capital (ARCC) announced a $3.4 million deal to acquire investment firm American Capital (ACAS). After American Capital ditches American Capital Mortgage Management (in a $562 million sale to American Capital Agency), the combined firm will have investments greater than $13 billion.
BDCs are closed-end funds whose primary mission is to lend money to small- and mid-sized companies. They are registered with the U.S. Securities and Exchange Commission, and because they must distribute 90% of their taxable income to their shareholders, their yields are above market. Consequently, they have wide appeal to investors.
As fears of interest rate rises permeated the markets in the fourth quarter of last year, prices of BDCs hit the skids. But it wasn’t only rate increases that scared off BDC investors; they also shied away from the sector for two other reasons: 1) anxiety that falling oil prices would hurt financial firms and 2) worry that their share price declines could prevent them from accessing capital markets and increasing their revenues.
But those fear factors really didn’t come to pass. Interest rate rises are moving at a snail-like pace, energy prices are recovering, and the BDC sector—on average—saw earnings growth of about 9% last year.
And as you can see from the following chart, BDC stocks (represented by Main Street Capital Corp., Goldman Sachs BDC and Triangle Capital Corp.) have staged a comeback since falling from their March 2015 highs.
And 2016 Looks Even Better
For 2016, analysts are predicting a pretty good year for BDCs. At the end of 2015, Keefe, Bruyette & Woods estimated that BDCs should give investors average gains of 15% this year. That includes 10% in dividend payments, the rest in appreciation. Seeking Alpha forecasted 17% returns for BDCs in 2016, and for the first quarter, they outperformed, gaining an average of 6%.
And Fitch Ratings reported that as of March 15, 2016, the BDCs they rate were trading at a 17.4% average discount to net asset value. Which means there’s lots of room for more appreciation.
Yet, the markets didn’t give ARCC or ACAS resounding applause on the news of their combination. However, sector experts think the merger will be shareholder-enhancing as it should result in larger loan syndications, generating bigger fees; greater diversification of its investments; and keep the current 10.25% yield steady, if not growing.
Our contributor, Adrian Day, editor of Adrian Day’s Global Analyst, agrees. He recommended ARCC in our Top Picks issue of Wall Street’s Best Dividend Stocks last January. And in an article this week, following the Ares/American Capital merger announcement, here’s what he had to say:
‘For long-term shareholders it’s a positive transaction. Ares is a great company. By combining the two largest BDCs into a company more than twice as big as its closest competitor, Ares will add scale and diversification, giving it the ability to originate larger transactions.
‘Ares acquired Allied Capital a few years back, and was very successful in consolidating that company and getting value out of its assets. The playbook will be much the same with American Capital, to rotate over time out of non-yielding equity investments and move into yielding assets, giving it the ability to increase its dividend over time.
‘Ares fully covers its dividend, and has spillover income amount to 82 cents per share to make up any dividend shortfall in the near term. Ares management will also waive up its fee, up to $100 million, over 10 quarters.’
BDCs with the Highest Current Yields
It’s an interesting time for BDCs. Yields are still very high and price appreciation is bouncing back.
Here are a few BDCs with the largest current yields in the sector:
But remember, yield isn’t everything. Investors must continue to monitor the fundamentals of the company because dividends can be cut or eliminated, and if that happens, stock prices tend to fall, too—a double whammy.
So make sure you frequently review your BDC holdings for:
- Portfolio quality
- Dividend consistency
- Sector diversification
- Leverage, which becomes increasingly important as rates begin to rise
And in the meantime, enjoy those high yields!
Happy investing,
Nancy Zambell
Editor, Wall Street’s Best Investments and Wall Street’s Best Dividend Stocks
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