High yield has been fair to overvalued for some time now and until recently continued its lofty ascent with few serious downdrafts. The I-Shares HYG ETF that represents a large portion of the high yield market began to crack in late June and then recovered into mid August where it began a serious decline as it is down 2.58% over the last month.

At times it is informative to look at other related markets to gauge overall health in a particular risk asset class. In this piece we will review Business Development Companies and how their performance may be indicative of risk appetite and the forward risk reward in credit.

To begin, we highlight the major characteristics this asset class possesses with a little history.

” In 1980, the U.S. Congress created a class of corporation called a business development company (BDC) to encourage the flow of public equity capital to private businesses. ” They likely did this in order to help facilitate the development of companies that were overlooked by larger lenders.

To qualify as a “regulated investment company,” a BDC must invest at least 70% of its assets in private or thinly traded, public U.S. corporations, and must distribute at least 90% of its taxable income to shareholders in the form of dividends.

BDCs must also make available significant managerial assistance to their client companies and make mostly short-term, unsecured loans in the $2 million to $50 million range. Also, they frequently take ownership positions (equity interest) in their client companies. Since they must pay out most of their profits to shareholders, BDCs must raise cash to fund expansion by selling more shares or via borrowing.
BDCs went through hard times in 2008 and early 2009 when the economy tumbled. Now, most have recovered, are financially strong, and well positioned to prosper if the economy continues to strengthen. ” Source-“Dividend detective”

As outlined above, BDCs invest in a very risky part of the capital markets that have the characteristics of high yield and private equity. These are both risky asset classes and a robust flow of credit is essential to both strategies.

The appeal for high yield and for BDCs is mainly the yield and the Fed induced reach for yield has many investors out on a risky limb. Let’s take a look at an I-Share representation of this asset class. The UBS ETRACS linked to the Wells Fargo Business Development Company Index(BDCS) represents finance companies that hold as their portfolio the debt and at times equity of the target companies. This is a solid business model in a growing economy where the BDCs can lend at low rates and earn the spread on the debt they own. If this relationship is threatened, losses can be immense as they were in 2008 when BDCs generally did much worse than the S&P500.

Over the last 3 months, this instrument has generated a return of negative 7% which is also about the timing of the slide in high yield debt. There are many factors at work in a complex system but we would like to provide some thoughts to help guide your next investment discussion on risk.

It is important to determine if we are entering a credit slowdown or a sharp deterioration in credit conditions. If those conditions are true, then both high yield and BDCs will likely do poorly. Also, if borrowing costs rise in the face of a faltering economy, it could be even worse.

We recommend that investors look past the 4.74% yield on the I-Share HYG and the 7% plus yield on the BDCS ETN and look to see if this is merely a risk off pull back or a sign from two markets that credit is going to become even more expensive.


Tom Koehler-CIO