BIZD vs PBDC ETF: High-Yield Income from Top BDCs

Key Concepts

• Business Development Companies (BDCs): Hybrid financial entities that lend to private, small, and mid-sized businesses unable to secure traditional loans, often at floating rates. They are legally required to distribute most of their income to shareholders as dividends.
• High Yield: BDCs are known for offering significantly high dividend yields, often exceeding 10% annually, due to the higher interest rates on the loans they provide.
• Write-downs: A potential risk associated with BDCs is the possibility of loan defaults, leading to write-downs. A healthy level is considered up to 1.5% of fair value, with anything above 2% suggesting management issues.
• Taxation of BDC Dividends: In the U.S., BDC dividends are typically taxed as ordinary income, making them more tax-efficient when held within tax-advantaged accounts like IRAs or 401(k)s.
• BIZD (VanEck BDC Income ETF): A passively managed ETF that tracks an index of BDCs. It aims to provide broad exposure to the BDC sector and is characterized by its large asset base and long history.
• PBDC (Putnam BDC Income ETF): An actively managed ETF that invests in BDCs. It is noted for its potentially better total returns compared to BIZD, attributed to active management decisions.
• Active vs. Passive Management: BIZD is passively managed, tracking an index, while PBDC is actively managed, with a fund manager making investment decisions.
• Total Return: A measure of investment performance that includes both price appreciation and reinvested dividends.
• Secured Overnight Financing Rate (SOFR): A benchmark interest rate that influences the floating rates of BDC loans.

Business Development Companies (BDCs) and High Yield Investments

This episode of ETF Spotlight, hosted by Daniel Snyder from Seeking Alpha, features analyst Julia Ostian discussing Business Development Companies (BDCs) and their role in high-income investing, with a particular focus on the BIZD ETF.

Understanding BDCs

Julia Ostian explains that BDCs are a misunderstood but attractive sector for investors seeking high yields, often above 10% annually. She describes BDCs as a hybrid between lenders, banks, private equity, and venture capital. Their core business model involves lending money to private, small, and mid-sized businesses that cannot obtain traditional loans. These loans are typically at floating rates, which are more expensive, leading to high income for the BDCs.

By law, BDCs are required to distribute a significant portion of their income to shareholders in the form of dividends, similar to Real Estate Investment Trusts (REITs). This is the primary reason for their high dividend yields. Ostian notes that if a BDC's business is sound and generating income, its dividend is unlikely to be significantly cut.

However, a key consideration for investors is the potential for write-downs. Since BDCs lend to businesses that may have difficulty securing traditional financing, they can experience a higher percentage of loan defaults. Ostian suggests that write-downs up to 1.5% of fair value are considered healthy, while anything above 2% might indicate poor management.

For income-focused investors, BDCs can be less attractive due to their tax treatment. In the U.S., BDC dividends are generally taxed as ordinary income, which can lead to a heavy tax burden in regular brokerage accounts. Therefore, U.S. investors often prefer holding BDCs within tax-advantaged accounts like IRAs or 401(k)s. Non-U.S. investors are advised to consult their tax advisors.

The ETF Approach: BIZD and Diversification

Daniel Snyder summarizes that BDCs serve businesses that cannot access traditional loans from large institutions like JP Morgan or Goldman Sachs. This comes with higher interest rates, increased risk, and potentially more volatility and bankruptcies. Instead of investing in individual BDC companies like Ares Capital or Blue Owl, the discussion shifts to the BIZD ETF (VanEck BDC Income ETF).

Julia Ostian advocates for the ETF approach, particularly for investors who are not professionally involved in investing. She finds researching individual BDCs to be overwhelming, requiring close monitoring of management decisions, Net Asset Value (NAV), performance, and write-downs. Even experienced investors, like her husband, prefer ETFs for their convenience.

The BIZD ETF is presented as an "S&P 500 of the BDC world," offering diversification across the sector. It provides exposure to most BDCs available in the market, simplifying the investment process. BIZD is a passively managed ETF that tracks an index of BDCs, requiring a minimum market capitalization of $150 million and a certain average daily trading volume for inclusion. It holds approximately 30 BDCs, with the top four (Ares Capital, Blue Owl, Main Street, and Golub) comprising about a third of the ETF.

BIZD has been in existence since 2013, having navigated various market cycles, including COVID-19, zero interest rates, rate hikes, and liquidity squeezes. This long track record provides investors with a sense of stability and reduces the need for panic-driven actions. BIZD has over a billion dollars in assets under management, making it a substantial ETF.

Impact of Interest Rate Cuts on BDCs

The conversation addresses the potential impact of anticipated interest rate cuts on BDCs. Julia Ostian believes the BDC sector has been oversold due to fears of rate cuts. She argues that income-focused investors prioritize dividends, and even if the dividend yield falls slightly, it might not be a reason to exit a position, especially if the stock price experiences minor drops.

She explains that a 25 basis point reduction in the Secured Overnight Financing Rate (SOFR) would lead to a similar or smaller reduction in BDC loan interest income. If multiple rate cuts occur, this could compress BDC top-line income by an estimated 75 to 125 basis points, potentially resulting in a 1% lower dividend distribution. While this is unfortunate for investors seeking a specific yield, Ostian emphasizes that yields in the 8% to 12% range would still be considered high for the market.

Furthermore, many BDCs offer special dividends, which are surplus distributions from income exceeding expectations. These special dividends are more likely to be cut than the base dividend. For ETFs like BIZD, Ostian anticipates a base dividend cut of no more than 1% to 1.5%. She concludes that rate cuts are not a reason to withdraw from BDC investments, especially when investing in well-managed funds that can adapt to different market conditions.

Comparing BIZD and PBDC ETFs

The discussion then shifts to the Putnam BDC Income ETF (PBDC), another ETF mentioned by Julia Ostian. While both BIZD and PBDC invest in BDCs, PBDC is actively managed, whereas BIZD is passively managed.

Ostian clarifies that she has given a "Buy" rating to both ETFs, despite some questioning PBDC's higher returns. She reiterates that BIZD is a passive index tracker with a broad inclusion criteria, leading to significant exposure to larger, established BDCs. Its long history provides a sense of security.

In contrast, PBDC, launched in 2022, is actively managed. This means a dedicated management team makes decisions about portfolio composition and weighting. While PBDC is smaller than BIZD (approximately seven times smaller in assets under management), it has demonstrated better performance. Since its inception, PBDC has outperformed BIZD by around 15% on a total return basis over three years.

Ostian trusts the management of PBDC, citing their extensive experience (20-30 years) in credit and BDCs. She views the active management of PBDC as a positive factor that has translated into its superior performance. While both ETFs hold similar core BDC names, the positioning and weights differ due to active management decisions.

Conclusion and Key Takeaways

The conversation concludes with Daniel Snyder and Julia Ostian emphasizing the importance of management in investment decisions and acknowledging the high-risk, high-reward nature of BDCs and market fluctuations.

Main Takeaways:

• BDCs offer attractive high yields but come with inherent risks, including potential write-downs and ordinary income taxation.
• ETFs like BIZD provide a diversified and accessible way to invest in the BDC sector, especially for less experienced investors.
• BIZD is a passively managed, large, and long-standing ETF offering broad exposure to BDCs.
• PBDC is an actively managed ETF that has shown superior total returns, attributed to its experienced management team.
• While interest rate cuts may slightly reduce BDC yields, they are not necessarily a reason to exit BDC investments, particularly for well-managed funds.
• Management expertise is a crucial factor in the performance of BDC investments, as highlighted by the comparison between BIZD and PBDC.

Julia Ostian's articles on Seeking Alpha are recommended for further insights into this space.