Podcast: Closed End Funds and Business Development Companies

It’s rare that Charlie Wright hosts a guest for a second time on Strategic Investor Radio, but for John Cole Scott of Closed-End Fund Advisors, he made an exception. Last time, Mr. Scott talked mostly about closed-end funds (“CEFs”), but this time business development companies (“BDCs”) are the main topic.

BDCs were legislated into existence when Ronald Reagan was POTUS, but they only really started to take off in the aftermath of the Financial Crisis. With banks unwilling to lend, small businesses turned to BDCs to provide alternative financing.

BDCs trade on an exchange like shares of stock. There are only 52 BDCs in the U.S., and 43 of them are debt-focused. A typical BDC venture loan is between $10 million to $25 million, with a duration of 3-5 years. According to John Cole Scott, most BDC loans are repaid early by businesses that want to raise new capital or lower their interest rates.

Historically, BDCs have yielded between 9-10%, but today they’re more typically at 11-13%. With yields on Treasurys and investment-grade bonds so low, BDCs may be an attractive option for income-oriented investors. According to Scott, an allocation of 5-10% of an income portfolio to BDCs could be prudent for diversification and as a low-correlation tool. BDCs have had a 40% correlation to the S&P 500 and a 15% correlation to municipal bonds over the past decade.

Although the total number of BDCs in existence is still small, the category has expanded in recent years. Charlie Wright said he used BDCs earlier in his career when there were only a half-dozen or so on the market. Scott’s Closed-End Fund Advisors has created an online database of all BDCs at BDCUniverse.net.

On the subject of CEFs, Scott said there are now 600 funds managing about $300 billion in assets, and that the average fund is trading at an 8-9% discount to net asset value.

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Note: this podcast was recorded in March 2016 and while the concepts are relevant to today, the data outlined above may be different.