BIZD - BIZD: Many BDC Managers May Not Have Your Best Interest In Mind

2023-03-28 16:56:32 ET

Summary

• With the number of retired investors growing, demand for ultra-high-yield investments has surged, creating potential market dislocations.
• The Business Development Company ETF BIZD is a popular choice due to its 11% yield and strong recovery after 2020.
• If a recession or credit risk event occurs again, do not expect the Federal Reserve to save risk assets like BDCs due to their significant leverage growth and inflationary limitations.
• BDCs may consistently underperform the market due to agency problems that incentivize managers to increase leverage and overlook risk for higher yields.
• The senior loan ETF BKLN may be a decent alternative to BIZD, offering a decent yield at much lower risk, although both carry notable recession and credit risk exposure.

Many individual investors today remain highly focused on stocks and ETFs that pay the highest dividend yields. Over recent decades, wealth has become more heavily concentrated in retirement-age people , encouraging a disproportional increase in demand for high-income-generating investment products. I believe that has created some market distortions, leading to overvaluation (or an underappreciation for risk) in many ultra-high dividend investments.

Some income investors focus primarily on funds with high dividend yields and pay minimal attention to the potential depreciation of invested capital. This is reasonable when capital losses are not permanent and do not impact dividends. However, shifting market dynamics may cause high dividend investments to suffer more permanent losses, negatively affecting dividend returns. While it is true that most "high yield" funds recovered quickly after the 2020 recession, interest rates are much higher today, and with inflation remaining persistent, the Federal Reserve has less capability to provide immense stimulus. Thus, investors in high-risk funds should consider the possibility of facing permanent losses to both capital and income if a recession occurs.

Risks Facing Business Development Companies

One notable example of high-risk, high-yield investments is Business Development Companies. "BDCs" are firms that invest in large pools of corporate loans to companies. They operate similarly to REITs with some tax advantages. BDCs work very similarly to banks, essentially allowing investors to play the role of a lending bank, using some degree of leverage to amplify income returns. Of course, they carry more considerable agency risks than banks, as BDC managers are generally focused on generating an income from fund expenses and occasionally take excessive risk exposure to drive investor demand through ultra-high yields.

BDCs are similar to banks as they "rise like an escalator and fall like an elevator." In good times, they generate high yields that deliver consistent returns. However, due to the risk profile of most BDC loans and leverage use, they can lose all (or most) of their equity value in a short period of loan losses rise. Additionally, most BDCs carry negative exposure to rising interest rates, particularly yield curve inversion, as it often disproportionately increases borrowing costs compared to loan returns. Unlike banks, BDCs do not have large depositor pools that offer near-zero-interest cash, generally borrowing well above the discount rate. Since the short-term borrowing rate is nearly 5%, many BDCs are at elevated risk of loan losses on variable-rate debt or low returns on older fixed-rate debt.

As you can see below, the popular BDC ETF ( BIZD ) has struggled to generate positive returns during periods of a declining yield curve or curve inversion:

Not all BDCs carry the same loan book and borrowing profile. Some are more focused on fixed-rate loans, and others on variable-rate loans. Most generally operate similarly to banks with variable-rate loans (that do not lose value when rates rise) and variable or short-term borrowing. In those instances, a sharp rise in interest rates does not directly negatively impact their profitability (since revenue and interest costs rise proportionately); however, variable-rate loans can see a significant increase in loan-loss risk given the sharp rise in interest rates. For example, most BDC loans are at riskier credit ratings, often paying 4-7% above Treasury rates. When interest rates were near zero, those companies were paying a 4-7% interest cost, but now they're paying closer to 9-12%, making it more difficult for some companies to continue to make interest payments.

Curve inversion has a more direct negative impact on BDC income since most BDCs lend at longer maturities than they're borrowing. Today's immense curve inversion is also an indirect recession signal that points toward the potential devaluation of high-risk loans. The significant decline in the US manufacturing PMI also supports this trend. Historically, higher-risk corporate credit spreads often spike when the manufacturing PMI declines. See below:

As the economy slows, more companies will likely face financial turbulence that causes default or increases default risk. In this situation, below-investment-grade companies, typically lent to by BDCs, have much higher default risk. Credit spreads on B-rated bonds (a similar rating to most BDC loans based on their return on assets) have risen since 2021 as the economy slowed. While there was a slight contraction in spreads in recent months, they spiked again over the past two weeks as many banks are forced to sell their loan books (often at discounts) to restore liquidity. This factor is critical for BDCs since their net asset values decline directly as credit spreads rise.

Given the ongoing decline in the PMI and immense curve inversion, I believe the economic pressure facing high-risk loans in BDCs is only beginning. Investors are seemingly complacent due to the allure of BIZD's 11% yield and BIZD's strong recovery after its massive losses in 2020. However, the situation facing BDCs today is fundamentally different because interest rates are much higher (creating more strain on borrowers), and crucially, BDC leverage is much greater. In 2020, the government changed laws to allow BDCs to operate at significantly higher leverage to encourage capital lending stimulus and discourage loan book sales. This change was mirrored in banks as the cash reserve ratio was reduced to zero, allowing for more leverage and discouraging loan sales. BDCs were previously limited to a 1:1 maximum debt-to-equity ratio but are now allowed to operate at 2:1. Virtually all of the largest BDCs in BIZD have taken advantage of the change and dramatically increased their leverage. See below:

These seven BDCs are the largest in BIZD and account for around two-thirds of its total assets . While these BDCs have not increased their leverage to the new limit, they've all increased leverage significantly enough to increase their risk of exposure to a recession. In 2020, if BDC and bank leverage limits were not increased, many BDCs and banks would likely need to sell loans to restore capital adequacy, potentially creating a cascading rise in credit spreads. Of course, today BDCs and banks generally operate at higher liabilities-to-assets, giving their equity materially greater exposure to recessions and changes to interest rates. Further, if another recession occurs, it is unlikely BDC leverage limits will be raised again, meaning many may be forced to sell loans at significant losses if credit risk grows.

The Bottom Line

While BIZD's 11% yield is attractive, it also has a nearly 11% gross total expense ratio. Its 11% yield comes after costs; however, roughly half of BIZD's potential returns are being given to managers and banks. BIZD's total expenses are elevated due to its expense ratio (which is reasonable at 40 bps), which is greatly compounded by the management expense ratios of its constituents. Most BDCs have higher management fee ratios of 1-2% of assets, which can be 4-6% of equity due to leverage.

For this reason, BDC managers are incentivized to increase leverage and risk exposure to attract investors with higher yields. In my view, most BDCs chronically suffer from a relatively weak alignment of management and shareholder interest, otherwise known as " agency problems ." This issue may be a significant reason BIZD chronically underperforms the S&P 500 and has a much lower Sharpe ratio .

I believe BIZD and most BDCs are very poor investment choices today, offering small returns compared to immense downside risk exposure. Given the numerous negative catalysts facing the lending market today, I think this risk is relatively imminent. Overall, I am very bearish on BIZD and believe most income-oriented investors should avoid the ETF or minimize exposure to reduce the risk of rapid and significant capital losses followed by a (likely) permanent decline in income.

Investors may avoid risk by investing directly in senior loans through ETFs like ( BKLN ). BKLN's assets are similar to those held by BDCs, but BKLN does not carry the same leverage risks and, most importantly, does not suffer from high compounded management costs. Since it is not leveraged, BKLN's dividend is lower at 8.2% . However, BKLN historically carries around a quarter of the volatility of BIZD (annual performance Stdev of 4.7% since 2013 compared to BIZD at 22% ). Importantly, I am not particularly bullish on BKLN since its assets suffer similar credit risk exposure to the economy and a potential rise in loan discount sales due to banks' solvency issues. That said, from a risk-reward standpoint, I believe BKLN offers investors similar potential returns at a tremendously lower risk than BIZD today.

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