1 Great Trend for High-Yield BDCs

Creditors are sending BDCs, like Fifth Street Finance (NASDAQ: FSC) and Ares Capital (ARCC 0.83%),a message: Keep growing.

The debt markets may have never been so good to high-yield business development companies, which raise funds in the capital markets to invest in smaller, private businesses.

Cheaper funding abound
The debt markets are so hungry for yield that BDCs are raising cheaper and cheaper debt. Recently issued BDC debt and preferred equity is trading well below the yield at the time of issuance.

The table below shows recent capital raises and compares the current yield to the yield at the offering:

Fifth Street Finance and Ares Capital Corporation are part of the larger, more established group of industry players, and both have investment-grade debt ratings. Not surprisingly, these two have been some of the most active in refinancing long-term debt and their credit facilities as rates decline. Along with Prospect Capital (PSEC -1.10%), these three BDCs enjoy access to unsecured institutional note market, which is less expensive and more expansive than retail channels.

Ares Capital is the undisputed leader in arranging cheap financing. If it weren't for the fact its recent issue is callable, it would likely trade at an even lower yield. Ares' non-callable debt maturing in 2018 yields just 2.76% at the current price.

Gladstone Capital is an interesting case. The company issued new preferred stock at 6.75% to refinance existing preferred shares at a face rate of 7.25%. Its most recent offering and subsequent trading on the market suggests that it could raise even cheaper seven-year capital today.

Do note that Gladstone likely uses preferred stock because it is too small to raise a reasonably priced round of debt financing. The company pays more for its secured credit facility than Ares Capital Corporation pays for five-year, unsecured notes! Even still, investors are willing to accept lower yields on its preferred equity raises than they were at the time of the offering.

Why it matters
BDCs are nothing more than a pile of debt and equity capital that is invested in... other companies' debt and equity.

In recent months, the yields BDCs earn on their investments have been in a broad decline. While declining yields crimp a BDC's profitability, the decline can be offset with lower funding costs.

Equity investors should appreciate the recent generosity of the debt markets -- cheaper financing is undoubtedly good for the industry and its shareholders.