BIZD: The Least Risky Way To Maintain BDC Exposure

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fotosipsak/E+ via Getty Images Overview The rapid hiking of interest rates was a great experience for me because it taught me how valuable of a sector that Business Development Companies can be for ...

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I previously covered VanEck's BDC Income ETF (NYSEARCA:BIZD) in my last article titled: 'BDC Are Still Great For 2024'. In that article, I discussed how BIZD was a great option for a 'higher for longer' interest rate environment where interest rates remained elevated. While the Fed has still not started to cut rates, there are some early indicators that suggest rate cuts may be on the horizon. I want to provide some thoughts on why BIZD may also be a great choice for an environment of lower interest rates. Data by YCharts Since the fund's inception dating back to early 2013, we can see that the price has fallen by about 15%. However, during the same time period, we have seen a total return performance of approximately 138%. This return can be attributed to the consistency of BIZD's high dividend yield. The dividend yield currently sits at 10.5% and provides a way for investors to offset the higher interest rate environment that we are in. Assuming rate cuts happen over the next 12 months, there is a chance that the distribution may be reduced. However, BIZD is still a great way to capture a high yield with a diverse exposure due to its underlying asset mix that generates income from debt investments. To provide some context first, BIZD is an ETF that has a wide range of BDC holdings within. The main goal of this fund is to replicate the price and yield performance of the MVIS US Business Development Companies Index. BDCs are companies that generate earnings through various forms of debt investments to companies that may not want to get traditional financing from banks. Therefore, we see these types of investments thrive in a high interest environment. Since BIZD offers exposure to a majority of BDCs, I believe this is the least risky way to get exposure to the sector while still collecting a double-digit distribution. Portfolio - Protection Through Diversity BIZD's holdings are diverse in nature, but they all seem to lean towards lending to middle market companies. This is because there is an abundance of middle market companies in the US that have an EBITDA between the range of $5M to $100M that may be seeking additional funding to assist with growth and expansion of their business. BIZD takes the guess work out of the process and gives you exposure to almost all of the BDCs that exist, while prioritizing the ones that it determines to be of highest quality. According to the most updated factsheet, BIZD also has a reasonable management fee of 0.40%. For a disclosure, the top ten holdings within BIZD consists of a handful of BDCs that I personally hold and continue to reinvest my distributions into. We can see that the top holding by percentage of net assets is Ares Capital (ARCC), accounting for 19.65%. This is followed by Blue Owl Capital (OBDC) which makes up 12.89% of net assets and FS KKR Capital (FSK) which accounts for 12.65% of net assets.   BIZD Factsheet Just for reference, here are the performance profiles of some of these top holdings in comparison to BIZD itself. In addition, I've also added the total return of the S&P 500 (SPY) just to illustrate how strong BDCs have performed over the last three-year period alongside the rise of interest rates. While outperforming the S&P 500 isn't a goal that everyone investor aims for, it serves as a good reference point of positive of an impact the rise of rates is for BDCs. Data by YCharts With this in mind, can expect a lot of business development companies to actually slash their dividend when the interest rates get cut. This is the natural course of the cycle, as lower interest rates directly translate to lower interest payments that the BDCs may receive on the variable rate debt they own. As a result, their net investment income per share totals drop and the distribution coverage shrinks. Sometimes, when a BDC isn't maintaining a large enough distribution coverage, it may need to slice the payout in an effort to compensate for the lower NII per share coming in. A good example to demonstrate this process is TriplePoint Venture Growth (TPVG) which recently saw its non-accrual levels rise. Non-accruals are the percentage of companies that are part of the BDCs portfolio that are no longer able to keep up with the required debt payments. As a result, they fall into delinquent status and fail to pay back their loan. This directly leads to a lower NII per share amount reported by the BDC and lowers the distribution coverage. TPVG's declared quarterly distribution is at $0.40 per share. However, their latest earnings results showed that NII per share amounted to $0.41 per share and missed expectations by $0.02. While the distribution is technically still covered, this only represents a very slight coverage of 102.5%, which is very likely to be reduced once rates are cut and NII per share comes in even lower. We can see the clear performance gap between BIZD, an excellent performing BDC like MAIN, and a poor performing BDC like TPVG. Data by YCharts There are tons of business development companies out there, and the diversity offered by BIZD can help eliminate the risk of choosing the wrong BDC investment. This is especially true for an income investor that may rely on the dividends produced from their portfolio; the last thing you want to experience is a dividend cut when you need the income produced to help pay your lifestyle expenses. There are plenty of BDCs that are out-earning their distribution with a large enough cushion that interest rate cuts should not affect the distribution even if NII per share drops. For example, here are some of the coverage rates of some of my favorite BDCs:   Blue Owl Capital (OBDC): $0.37 per share distribution, with reported NII per share of $0.47. Coverage rate of 127%.  Main Street Capital (MAIN): Incredible dividend coverage of 142.8%. This is one of my favorite BDCs, which I previously rated as a buy.  Hercules Capital (HTGC): Reported NII per share of $0.50 with a distribution of $0.40 per share. Equals out to a distribution coverage of 125%.  Downside Of Diversity While diversity is a great thing to minimize risk, the downside is that you may be limiting your total return with the inclusion of subpar holdings within. There are some BDCs that have historically underperformed the rest of the sector for their own varying reasons. This is in no specific order, but below are some examples of those underperforming BDCs. Just to be clear, an underperforming BDC doesn't automatically mean that there are underlying issues with the fund. There may be some outside influences effecting the fund. Data by YCharts Each BDC has its own strategy and exposure to different sectors. Additionally, each BDC has its own underwriting process that may leave vulnerabilities to specific sectors in their portfolio. Whatever the underlying root cause of underperformance might be, the downside is that you are capturing this when holding BIZD. Why not just hold the higher quality ones, you might ask? Perhaps there are investors that don't necessary care to be always actively managing their portfolio of BDCs and would much rather hold a diversified bundle of holdings. This diversity may come at an added cost, however. Most investors are searching for sweet income deals within this sector, and BIZD's ETF format eliminates one of the main appeals of the sector: supplemental distributions and raises. BIZD's dividend history shows us no supplemental distributions ever being issued out to shareholders. In this higher interest rate environment, there are a ton of BDCs that have performed very strongly by generating higher levels of income than originally anticipated. As a way to reward shareholders, they've issued an abundance of supplemental payments that boost the total amount of income received over the course of the year. Some examples of these are:   Main Street Capital (MAIN): due to strong performance, they have boosted the dividend by 2.1% while also announcing a supplemental distribution of $0.30 per share, which is higher than its regular base distribution.  Capital Southwest (CSWC): recently announced a supplemental distribution of $0.06 per share.  Blue Owl Capital (OBDC) declared a supplemental distribution of $0.08 per share, while also raising the base distribution by 5.7%.  Dividends & Financials Speaking of distributions, BIZD's most recently declared quarterly distribution of $0.4579 per share brings the current dividend yield up to 10.5.%. Therefore, you are still capturing a double-digit yield even though BIZD's diversity may not allow you to directly take part in the supplemental distributions of other BDCs. Despite the lack of consistent raises or supplementals, the dividend growth here can be quite consistent over a long period of time. To help visualize this, I ran a back test with Portfolio Visualizer to show what kind of income an original investment of $10,000 would have net you. This graph assumes an original investment at the beginning of 2015, but also consistent fixed contributions of $500 per month throughout this entire holding period. The graph also assumes that all dividends received were reinvested back into BIZD and helped buy more shares. This level of consistency and long-term commitment helps establish a sizeable dividend snowball that compounds your dividend income over time.   Portfolio Visualizer In 2015, your dividend income would have totaled $1,134. Fast forward to 2023, and we can see that your dividend income would have grown to $8,907. So, even though BIZD may not enable you to take part in a consistent level of growth through raises and supplementals, you can still create your own growth by a long-term commitment. However, there are some flaws here with the distribution that can be spotted when looking at the latest annual report. The distribution of BIZD are funded by the net investment income received from holdings as well net realized gains. However, when NII per share and net realized gains cannot cover the distribution, BIZD relies on return of capital to make up the difference. We can see that in 2023, NII per share amounted to $1.63, but this was offset by $2.18 per share in net realized losses. Therefore, BIZD had to rely on prior year and 2021 earnings to fund some of the distribution. Additionally, BIZD implemented a return of capital worth $0.04 per share. So far, this has been the first year that BIZD has implemented ROC, so there are no worries as of yet.   BIZD 2023 Annual Report However, prolonged use of ROC can erode the net asset value of BIZD. This is because return of capital translates to investor money being taken directly out of the NAV and returned back to shareholders. As a result, we can see that NAV decreased down to $14.54 per share from the prior year's amount of $16.76 per share. While this is mostly negative, at least the return of capital was relatively small. Additionally, this can actually lower your tax burden from holding BIZD since the normal distributions are classified as ordinary dividends which are taxed at unfavorable rates. Return of capital typically aren't considered income, and therefore taxed at more favorable rates. Valuation It can be difficult to measure an exact valuation for BIZD since it encompasses holdings that typically operate on a basis where the price can vary from the actual net asset value. However, there are some influences that we can reference in terms of price movement and value. Interest rates are arguably one of the largest influences on the price of BDCs. While higher interest rates have definitely translated to higher income for shareholders throughout higher interest payments, it has also slowed the volume of interested borrowers. However, when interest rates start to drop, we may see the volume of potential borrowers increase. Lower rates make an environment of borrowing more attractive since the cost of capital gets cheaper. I anticipate that with future interest rates on the horizon, we will see an environment of higher loan interest, which may actually offset any projected drops in NII per share. The fed left rates unchanged at their last meeting as they await more economic data to roll in around inflation, consumer spending, and the labor market. However, they do forecast at least one interest rate cut by the end of the year. I tend to agree with this outlook, as I also believe that interest rates will be cut by the end of the year. The unemployment rate has now started to slowly tick above the 4% mark for the first time since January 2022. Another roadblock for interest rates has been the consistently high levels of inflation experienced. Inflation has now slightly ticked down for two months in a row, coming to 3.3% in May. If interest rates continue to come in lower, this will increase the chance of the Fed initiating the first cut. Data by YCharts Additionally, we see that the price of BIZD and the federal funds rate has seen a bit of an inverse relationship. As rates were cut to near zero levels in 2020, the price of BIZD started to rapidly move appreciate upward. However, when rates started to get hiked in 2022, we saw the price momentum slow. This slowed price growth can likely be attributed to a combination of a lower volume of borrowers in this environment and the fact that a lot of BDCs are starting to experience rising non-accruals, as previously mentioned. BIZD offers a way to offset the risk of these rising accruals through its diverse holdings. However, my thoughts surrounding the outlook of BDCs aren't alone, as we also received a similar outlook from the CEO of Gladstone Investment (GAIN) during the BDC's last earnings call. The backlog of new opportunities has been building and we've actually been hearing from the investment bankers and the other folks that we deal with in finding new opportunities that backlogs are building. I'd say the quality we're seeing is okay frankly but the volume is clearly back to levels that we were seeing before. - David Gladstone, CEO  Therefore, I believe that the cutting of interest rates could show some price upside back above pre-pandemic levels, even though NII per share may decrease at first. I believe that the higher amount of active borrowers will present a lot of new opportunities for these BDCs to capitalize on. Additionally, lower interest rates should help these BDCs make improvements on non-accruals, as it provides current borrowers with some relief through lower interest payments. Takeaway  In conclusion, I maintain my buy rating on BIZD as I believe it may be one of the least risky ways to maintain exposure to the business development company sector. The diverse range of holdings provides exposure to an abundance of different BDCs with varying strategies and industries of focus. Even though BIZD may not reward shareholders with all of the supplemental distributions or base raises, it delivers a consistent enough distribution that can create a compounding effect on your dividend income. Additionally, future interest rates may actually be a good thing for BDCs, as this increases the volume of borrowers as debt becomes cheaper to access. Additionally, lower interest rates may provide some relief to companies in non-accrual status and improve the overall health of the sector, despite NII per share dropping.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.24.2","shortVersion":"4.24.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2446841034"}