After a dismal performance in 2014, business development companies are enjoying a reversal of fortune, floating to the top of the leaderboard in the New Year. They’re outpacing their interest-rate sensitive brethren, utilities and REITs, bonds and the S&P 500 alike amid widespread anticipation that the Federal Reserve will lift interest rates mid year. As the stock market grows ever more expensive and profit margins are reaching record highs, the catalysts that should drive outperformance in BDCs grow stronger and stronger considering that most BDCs are trading at single-digit multiples and less than book value. Yet they’re paying double-digit dividends. What’s more, rising interest rates would indicate that the Fed is convinced the economy, employment rate, consumer sentiment, business prospects and inflation are all improving. Thus BDCs, which invest in small businesses to help them grow, have a brighter outlook than ever.
The ETRACS Linked to the Wells Fargo Business Development Company Index ETN (BDCS), a debt note which tracks a portfolio of BDCs, gained nearly 5 percent year to date versus 3 percent for the SPDR S&P 500 ETF (SPY), as of February 28, according to Morningstar. Bonds have added 1 percent and REITs (VNQ) ticked up 2 percent while utilities (XLU) tumbled 4 percent year to date.
BDCS fell 9 percent in 2014, severely lagging the SPY’s 13 percent rally. Their underperformance could partially be blamed on getting booted from the S&P and Russell indexes. The decision was made primarily to make mutual fund and ETF managers’ lives easier and had nothing to do with the merits of investing in BDCs. Because BDCs are structured like mutual funds, they have to pass on certain business expenses as extra “acquired fund fees” that get reported in mutual funds or ETFs’ expense ratios. So dropping BDCs from the indexes simply alleviated this aggravation and expense for fund managers.
In addition, small caps lagged in general after outpacing the S&P the year prior. iShares Russell 2000 ETF (IWM) returned just 5 percent in 2014. BDCS also lagged the bond market’s (BND) 6 percent return last year.
However, a fat dividend yield cushioned the blow. BDCS distributes a quarterly coupon and yields 8.48 percent at the moment.
BDCs may actually benefit from rising interest rates and offer a few advantages over other high-yielding securities. BDCs borrow at a fixed interest rate while loaning money at floating interest rates. Therefore, their earnings would improve if interest rates rise considerably. Bonds will surely lose principal when rates rise because price and yields move opposite each other.
Utilities tend to fall out of favor in a rising-rate environment because of the monster debt loads they take on to build new infrastructure. They sport some of the highest debt-to-market values. Government regulations makes it politically difficult for them to pass on higher costs to their customers. When earnings shrink, so do their financial ratios. They fall prey to lower credit ratings as a result of declining debt-to-equity and interest-coverage ratios. The lower a company’s credit rating, the higher the interest rates they have to borrow at, creating a vicious cycle.
History has shown that rising interest rates dampen demand for real estate because of higher borrowing costs. However, demand could also improve in the face of strong economic growth. Rising inflation may encourage people to buy before prices rise.
A study published by Altegris in April 2014 found that a hike in the Fed Funds rate doesn’t necessarily hurt REIT performance, unlike other traditional fixed-income assets. In the seven periods since 1972 when interest rates rose, REIT share prices climbed in five instances and fell in two. How REITs will fare this go around is a wildcard. But what’s certain is that they’re trading at sky-high valuations at nearly 43 times earnings and 2.5 times book value. If they revert to the mean, investors are in for a rude awakening.
Bargain Basement Valuations