The ABCs of Pass-Through Securities: Business Development Companies

In this third article of a four-part series about pass-through securities, investment expert Will Rhind breaks down business development companies and their potential appeal to retirees seeking income.
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By Will Rhind

As an income crisis continues to plague the U.S. economy, pass-through securities offer an appealing option to many investors. Their primary benefit? Being exempt from corporate taxes. The tradeoff for this status is that pass-through securities must distribute essentially all of the income they generate. In many ways, they are similar to mutual funds in that the fund itself is not a taxpayer but rather passes on its income to underlying shareholders, who then must pay the applicable taxes.

Will Rhind

Will Rhind

This is the third article of a four-part series examining pass-through securities, which previously covered real estate investment trusts (REITs) and master-limited partnerships (MLPs). Here, the focus will be on business development companies (BDCs), before the series concludes with an article on closed-end funds.

Ongoing Income Issue

The greatest attraction right now of business development companies, and pass-through securities more broadly, is their ability to help overcome the widespread difficulty in finding yield. The origins of this problem date back to the financial crisis of 2007-08, because interest rates were dropped to almost zero in response to it.

The Federal Reserve then took about seven years to start raising rates again. This proved to be a gradual process, as rates increased only modestly compared to historic levels before the pandemic hit last year and caused another decrease to zero. Basically, the backdrop to retirement and income since 2008 has been a desperate search for yield.

Now, we face a scenario where interest rates will most likely remain historically low for the foreseeable future. Part of the reason for that is the broader macro environment, as the setting of rates goes hand in hand with monetary policies. Those have been extremely accommodative, essentially combining to take all the income out of public markets.

The first week of March saw a downturn in market performance because long yields were rising and people started getting nervous. But even so, the 10-year Treasury note is still only yielding 1.62%, hardly a level that would allow someone to enjoy a comfortable retirement.

What spooked the market even more in March was the potential impact of inflation. If you subtract 1.62% from the level of inflation, which we’ll call 2% for argument’s sake, the result is negative real interest rates even with the Treasury yield’s recent increase.

Breaking Down BDCs

BDCs come into this conversation as publicly traded organizations that help small to medium-sized businesses grow by investing in them, typically via money lending. Congress created BDCs in 1980 to fuel job growth and assist emerging businesses in raising funds.

In order to qualify as a BDC, an entity must be registered as an investment company. From a tax perspective, this makes it look and feel more like a mutual fund than a regular company such as Apple, for example. A BDC must also invest at least 70% of its assets in either private or public U.S. firms with a market capitalization of less than $250 million.

According to Closed-End Fund Advisors, there are currently 48 public BDCs totaling approximately $47 billion in market cap. Thus, BDCs represent the smallest category of the four pass-through securities covered in this article series, behind the 479 closed-end funds, 166 REITs and 71 MLPs.

Tax Treatment

In a market environment where people are looking all over for yield, securities like BDCs, REITs, MLPs, and closed-end funds present intriguing possibilities. The high yield potential of BDCs, similar to all pass-through securities, is due to the way they’re taxed.

The minimum corporate tax rate in the U.S. is currently around 22%, and President Joe Biden has talked about raising it much higher than that. While BDCs avoid this levy, regular companies see it skimmed off the top before underlying investors can receive any income.

The risks associated with BDCs also reflect those of pass-through securities, in general. If an asset is generating significant income, the flip side is typically a higher level of risk. When a company is lending to and investing in small to medium-sized businesses, it’s arguably more risky than doing so with large-cap or mega-sized businesses.

This is especially true if a BDC has invested in private companies, because they can be illiquid, or in public companies that might be thinly traded. Additionally, BDCs often employ leverage, borrowing the money that they then invest in or loan to target companies. Although that may improve the rate of return, it can also raise the risk profile.

Retirement Relevance

For retirees and near-retirees, BDCs can play an important role in portfolios because of their potential to generate a level of income almost impossible to find anywhere else. To offer some perspective, the MVIS US Business Development Companies Index (MVBIZD) tracks the performance of the largest and most liquid business development companies incorporated in the United States. Its current dividend yield is an impressive 8.93%, versus the 1.48% offered by the S&P 500.

To mitigate the possible risk of investing in BDCs, it would make sense to diversify your portfolio with other pass-through securities from different sectors, thus avoiding exclusive exposure to a BDC that might make poor investments and lose value.

It’s also important to be aware of the cost structure of BDCs. Fees associated with BDCs may seem high at first glance due to their tax treatment. With a regular company, people typically care most about the share price and the revenue minus expenses, equating to the profit.

Because BDCs are organized under the ‘40 Act, they must declare expenses like a mutual fund would. So if you see a BDC with a 10% expense ratio, for example, it might not seem attractive. But the actual activity of a BDC is much more like a regular company than a mutual fund.

To alleviate potential confusion, the Coalition for Business Development sent a proposal to the Securities and Exchange Commission in 2019 that would exempt the industry from current reporting requirements, arguing that these distort expense ratios and can dissuade investors who might otherwise be attracted to BDCs.

Future Focus

Assuming that the broader yield environment stays low, I believe the future is bright for BDCs. This is because they not only generate yield, but also serve an important purpose in providing capital to small and medium-sized businesses. All things being equal, that’s a sector of the market investors should want to see growing. Although special purpose acquisition companies (SPACs) could potentially fill some of this capital-providing role, they tend to focus more on larger businesses.

The demand for income ensures there will be capital entering the space, meaning people can continue to raise or form BDCs and deploy that capital to other companies. As the current income crisis continues, that translates to an appealing opportunity for investors.

About the Author: Will Rhind

Will Rhind is the founder and CEO of GraniteShares, a New York-based independent exchange-traded fund (ETF) issuer that seeks to launch innovative and disruptive ETF investments. Will is an established ETF entrepreneur with more than 20 years of experience in the industry. Prior to founding GraniteShares, Will served as the CEO of the World Gold Trust Services, overseeing the world’s largest commodities fund. He was also a senior executive at ETF Securities from 2007 to 2013 as well as a former principal at iShares. Will is a graduate of the University of Bath in England.

Past performance is not a guarantee of future results. One cannot invest directly in an index. For full disclosure, GraniteShares manages the GraniteShares HIPS U.S. High Income ETF (HIPS), which invests in a basket of pass-through securities.