Business Development Companies: High Yields, Big Risks?

Recent statements from the Federal Reserve suggest that higher interest rates may soon be in the offing—but it could be some time before Treasury bonds and other traditional fixed income investments offer truly attractive yields. So what can income-hungry investors do now?

One potential solution is business development companies (BDCs), which provide financing to fledgling or struggling companies that may be unable to obtain bank loans or raise capital elsewhere. Because BDCs—which trade like stocks but are managed like funds—invest in higher-risk businesses, they can charge higher interest rates on their loans and, in turn, provide attractive yields for investors.

The tax structure of BDCs may also bolster yields. "BDCs can elect to be taxed as regulated investment companies, which means they're exempt from corporate income tax so long as they distribute at least 90% of their profits, typically as dividends, to shareholders," says Steven P. Greiner, Ph.D., managing director of Schwab Equity Ratings^® at the Schwab Center for Financial Research. "The result is high-single-digit to low-double-digit yields that far outpace many traditional fixed income products and even some dividend stocks."

As with other high-yield investments, however, BDCs should be approached with caution. "First and foremost, most BDCs are publicly traded companies—not bonds—and come with the same market risks as other equities," Steven says. Beyond that, BDCs:

• Are sensitive to interest rates. BDCs use borrowed money to provide financing to other companies at higher rates. As interest rates rise, a BDC's profit margins could suffer.
• Are subject to credit risk. The types of companies BDCs invest in may be more likely to default on their loans or even go out of business, which could undermine overall returns.
• Charge high fees. In addition to their relatively steep management and service fees (typically ranging from 1.5% to 2%), BDCs may charge up to 20% in incentive fees on profits earned.¹
• Lack transparency. Because BDCs generally invest in private companies, which aren't required to make public disclosures, it can be difficult to assess a BDC's true risk-reward profile.

Those who feel comfortable taking on these risks might still consider investing in a BDC exchange-traded fund or mutual fund rather than an individual BDC. "Funds provide exposure to multiple BDCs in a single investment, which reduces the impact any one BDC will have on your portfolio," Steven says. "That said, remember that BDCs are relatively risky and should be viewed as part of your stock allocation, not your fixed income portfolio."