BDC ETFs Under the Microscope - ETF News And Commentary

It might be the right time to look for Business Development Companies (BDC), which have been badly beaten down since the start of the year. The meltdown has made the stock prices compelling at the current levels.

BDCs offer outsized payouts irrespective of market conditions and the potential for capital appreciation in the booming market. Investors' never-ending quest for high yield securities in the current ultra-low yield environment might encourage investors to think about this space. This is because these often lend to small and mid-sized (or middle-market) companies at relatively higher rates and often take debt or equity stakes in such companies (read: 4 Overlooked ETFs with Double-digit Yield).

Though the U.S. equity market has been climbing, geopolitical risk and global slowdown still weigh on the stocks' rally. Meanwhile, the American economy is faring stronger than expected, bolstering the case for interest rate hikes sooner than expected. Since BDC structures approximately 60% of its assets as floating-rate investments, increase in interest rates will boost interest income, profitability and dividend coverage.

On the other hand, the majority of the BDCs liabilities are made on fixed rate terms. So if rates rise, these companies will benefit from fixed-rate financing. Further, BDCs possess some quality of other income investments such MLPs and REITs as these requires distributing more than 90% of their annual taxable income to shareholders, according to the U.S. law.

Moreover, these companies have lower correlation with other fixed-income asset classes and are required to maintain low leverage, suggesting higher returns with lower volatility (read: Short-Term Bond Yields Rising: Where to Go Now for Fixed Income ETFs?).  

Give the promising outlook, investors could take advantage of the current depressed situation and invest in the BDC space in the form of ETFs. Currently, there are three ETFs in the space, each of which are different from the other:

UBS ETRACS Linked to the Wells Fargo Business Development Company Index ETN (BDCS)

This product tracks the Wells Fargo Business Development Company Index, which is a float adjusted capitalization-weighted index that is intended to measure the performance of all BDCs. The benchmark consists of about 32 companies in total, all of which have a focus on the U.S. market. The note focuses on pint-sized companies although it is somewhat concentrated as the top three holdings — American Capital (ACAS), Ares Capital (ARCC), and Prospect Capital (PSEC) — make up for nearly 10% share each.

Investors should note that BDCS is structured as an ETN which means that it has the credit risk of UBS but does not suffer from tracking error or complicated tax treatments either. It has amassed just $71.3 million in its asset base. Total trading cost is pretty high as expense ratio came in at 85 bps while volume is light, suggesting wide bid/ask spreads. However, the product does have a truly impressive yield of about 7.31%, which should help mitigate the cost issues. The note is almost flat in the year-to-date time frame.

UBS E-TRACS 2xLeveraged Long Wells Fargo Business Development Company ETN (BDCL)

This is a leveraged ETN and seeks to provide two times (2x or 200%) exposure to the performance of the Wells Fargo Business Development Company Index (or BDCS). The product has attracted $246.5 million in its asset base and is liquid with trading volumes of roughly 164,000 shares per day. BDCL pays out a whopping 15.48% in annual yields and has generated almost flat returns (see: all leveraged ETFs here).

Market Vectors BDC Income ETF (BIZD)

This fund follows the Market Vectors US Business Development Companies Index. It has AUM of $48.2 million and trades in light volume of 20,000 shares per day on average. The ETF is largely concentrated on the top 10 holdings at 63.1% of total assets. ARCC, PSEC and ACAS occupy the top three positions with a combined share of 28%.
    
In total, BIZD invests in 29 firms with a relatively high level of concentration in the top names. Ares Capital accounts for 11.8% share while Prospect Capital and American Capital make up for 8% each. The portfolio is skewed towards pint sized securities at 89% while mid caps account for the remainder. Dividends come in at impressive 6.68% while the year-to-date return is less than 1% (read: Is the Worst Over for Small Cap ETFs?).

Investors should note that this is one of the unique products from an expense ratio perspective. The direct expenses come in at 40 bps a year, and are capped to stay there until Sep 2015. However, ‘acquired fund fees and expenses' come in at a whopping 8.77%, greatly increasing the gross expense ratio, and resulting in a net expense ratio of 9.17%.

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E-TRC WF BDCI (BDCS): ETF Research Reports
 
E-TRC WF BDCI (BDCL): ETF Research Reports
 
MKT VEC-BDC INC (BIZD): ETF Research Reports
 
AMER CAP LTD (ACAS): Free Stock Analysis Report
 
ARES CAP CP (ARCC): Free Stock Analysis Report
 
PROSPECT CAP CP (PSEC): Free Stock Analysis Report
 
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