One of the largest sec¬tors of the U.S. economy is comprised of smaller private companies that typically generate between $50 million and $2.5 billion in revenues. These middle market companies exhib¬ited 7.8 percent revenue growth, for the 12-month period ended in 2018, compared to 4.7 percent for the S&P 500.
Banking regulations have changed over the last 20 years. These changes have made it much more difficult for traditional banks to make loans to companies in this arena. In 1995, 33 percent of banks were making loans to these companies, yet today, only 3.9 percent of banks are active in this space. These middle market companies are now forced to pay higher interest rates for access to capital needed to finance growth. Because of this need, Congress created a new type of lender to serve this market called business development corporations (BDC) to encourage capital flow to small and mid-sized companies.
Loans made to these companies are typically senior-secured floating rate, meaning they occupy the senior most position in a company’s capital structure. These loans are generally secured by a company’s property, plant equipment, or other collat¬eral, and have priority over a company’s shareholders and unsecured creditors.
What’s attractive about these loans for investors is they typically pay almost 4 percent more per year in interest than high-yield bonds; they also have had less default losses than high-yield bonds. At the end of 2018, the Cliffwater BDC index was yielding 10.7 percent compared to 6.5 percent for the Barclay’s High Yield Bond Index. Moreover, the interest rates float higher or lower with prevailing market interest rates.
Therefore, floating rate loans don’t have interest rate risk to the lender or investor. If interest rates rise, so does the interest paid to the investor. This asset class can provide a very nice yield to investors. However, the underwriting of these loans is critical, and investors should look for BDC’s with an excellent track record of low default rates.
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