What's the Best Investment in the BDC Space?

BCDs are an unfairly overlooked investment sector. See how Prospect Capital, Market Vectors BDC Income ETF, and Ares Capital offer three different ways to invest in this space.

Apr 9, 2014 at 6:33PM

Business development companies, or BDCs, are an important part of the market, investing in small and middle-market companies that are often overlooked by banks. For dividend investors, there are great opportunities in this space, as these companies can avoid corporate taxes, allowing income to flow to shareholders. Of course, some BDCs are better than others. Let's look at some of the best choices and strategies available for investors looking to gain exposure to this section of the market.

Prospect Capital (NASDAQ:PSEC)
One of the most popular choices in this space is
Prospect Capital, a BDC that has made an entrance into new market sectors in recent quarters. Key examples here include new investments in auto lending and rental properties, but recent moves suggest that Prospect is looking to start focusing once again on its core strategies, such as senior unsecured debt. The most obvious advantage of owning the stock is its massive dividend, which is paid annually and currently yields 12.2%.

But there are tremendous opportunities for growth as well. Let's delve into the gains made in Prospect's reported assets over the last three years.

During the first quarter of 2014, Prospect closed more than $1.3 billion in loan originations. This Q1 increase was a record for the company and more than double the $607 million posted during the fourth quarter of last year. Prospect should start to see the benefits of this increased loan activity during the second quarter, and its added access to small-business lending is now poised to generate even greater returns for shareholders. The company has recently announced plans to support the recapitalization of Harbortouch Payments and to aid in IWCO Direct's refinancing deals, giving Prospect strong positioning in merchant lending. This is a highly competitive sector where it can be difficult to establish a foothold, given the complications of developing sustainable relationships with a stable borrower. Prospect Capital has not seen a loan enter into non-accrual status in more than five years, and all of these factors support the outlook for the stock in 2014.

Market Vectors BDC Income ETF (NYSEMKT:BIZD)
While Prospect Capital offers some of the most stable (and highest-paying) exposure to the BDC space, the Market Vectors BDC Income ETF has positions in Prospect Capital and 27 other BDCs, offering diversified exposure to the industry. Other notable holdings include Ares Capital (NASDAQ:ARCC), which is one of the biggest names in the sector with more than $8 billion in reported assets. Ares Capital focuses on a wide variety of industry segments in an investment portfolio that includes roughly 200 companies. Diversified exposure of this type can come in handy if one of the invested companies finds itself in default, as the overall impact on Ares' income stream would be limited.

Ares Capital's dividend doesn't compare to Prospect Capital's: Ares' stock yields 8.7%, so that's part of the price you pay for the greater diversification. For those looking to gain high-yield exposure in the BDC space, Prospect Capital is the best choice.

If your stance is more conservative, Market Vectors BDC Income ETF is still a suitable option for broad exposure. And its dividend yield, at nearly 7.9%, is still high compared to what is seen in other market sectors. This ETF is often knocked for its expenses, which at first glance might appear high at nearly 9.4%. But most of this number comes from the acquired fees that are not paid by investors, so the dent on total returns is not as extreme. This is because any ETF that buys into other funds (essentially a fund of funds) is required to include the underlying funds' fees as well.

In any case, the BDC space has options for nearly all investors. There are many options available for dividend investors who are looking to add some exposure to business development companies. Prospect Capital remains at the top of the heap -- but it is important to remember that that is more than one way to invest in the company.

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