One of the more obscure class of investment securities is “Business Development Companies.” They are well-known for their large distributions and their high risks. However, in an environment where “safe” fixed income investments yield perhaps 2%-3%, should investors consider them? Some investors may believe the risks are justified since some well-diversified bond funds have lost 8% of their principal in 2022.

BDCs were created by Congress in 1980 to stimulate investment in middle-market U.S. companies. Those are companies that have earnings before interest, taxes depreciation and amortization of about $10 million to $50 million. BDCs are traded on stock exchanges, and they can pass through investment income without paying corporate income taxes; the investor pays any required taxes. BDCs are required to invest at least 70% of assets in the non-public debt and equity of U.S. companies and annually distribute at least 90% of their income to stockholders.

A partial list if risks intrinsic to BDCs: underlying company credit and investment risk; leverage risk as BDCs borrow money to make investments; illiquidity risk as the underlying companies may have no ready market; capital markets risk as BDCs rely on being able to easily borrow money.

BDC’s results have been mixed, even with 2018 legislation that increased the amount of leverage they could use. Using leverage allows them to invest in less risky companies while potentially not impacting their returns. Since that legislation passed, the results of the Wilshire BDC index have been mixed. For example, over the last one and three years, the total return of the Wilshire BDC index was respectively +38.07%% and +18.37%. However, it lost 6.42% in 2020, while the Wilshire 5000 was up 20.82%. Over the one- and three-year periods the Wilshire 5000 was +26.7% and +26.11%

As noted, the recent performance of BDCs has been OK. However, if we look a bit longer, five-year returns were +10.19% versus the Wilshire 5000’s +18.11%, and 10-year returns of +10.53 versus the Wilshire 5000’s +16.4%.

High-dividend yield is a characteristic of BDCs. Over the last 10 years BDCs have generally been one of the highest yielding securities. Historically, BDCs have yielded over 1.5 percentage points more than high-yield bonds (their main competitor) and 7 percentage points more than 10-year U.S. Treasury securities. Recently it wasn’t difficult to find BDCs with current yields between 7% and 10%.

While future returns are uncertain, an index due to research firm Cliffwater shows BDCs were recently trading about 1% above their net asset value. Even with this, their high yields suggest they could provide a higher total return than high yield bonds, whose yields recently were in the 4%-6% range. On the negative side, BDCs have about 2.5 times the volatility of high-yield bonds.

Since they invest in illiquid companies, there is the danger that the value that these are estimated to have may differ significantly from their actual value. This could mean that the BDC's advertised net asset value is misleading.

One way to think of an investment in BDCs is as a liquid alternative to an illiquid hedge fund private equity investment.

All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at rsstepl@tampabay.rr.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.

This article originally appeared on Sarasota Herald-Tribune: ROBERT STEPLEMAN: Business Development Companies: What's the attraction?