Published: May 5, 2010

Most of the time, there's a trade-off between yields and capital gains. Want a stock that could rapidly rise? You'll have to give up a high dividend yield. Want a stock that pays double-digit income? The share price is unlikely to rise too much.

But I'm spotting a largely unknown corner of the market that offers the best of both worlds -- strong yields of 10% or more, combined with rising share prices.

Most investors haven't heard of business development companies (BDCs). These securities give ordinary investors the ability to play in a higher-risk/higher-reward arena usually reserved for large institutions or wealthy venture capitalists.

You see, BDCs are essentially venture capital firms open to the public. The companies borrow at long-term rates and loan money to small companies that can't secure financing from traditional sources.

The good news for us income investors is that many of these companies provide strong yields, and their share prices are soaring. For example, I added one company to my High-Yield Investing "10%-Plus" Portfolio about six weeks ago, and already it's ahead more than +12%. That's not unusual; many other BDCs have seen a similar rise.

So what's driving this group of some three-dozen high-yield companies?

Like other companies, BDCs can raise capital by selling shares or securing bank lines of credit. But one source of funding is unique to BDCs: loans issued by the federal government's Small Business Administration to BDCs licensed as Small Business Investment Companies (SBICs).

These loans provide the BDC with secure long-term financing. Typically, the loans are several hundred basis points above the 10-year Treasury, and carry about a 6% interest rate. Depending on the type of loans they make, they can lend at rates higher than 14%, pocketing the spread.

With proper credentials, a BDC can borrow up to $225 million. There is a bill working its way through Congress that would even raise the borrowing limit, providing additional capital for BDCs.

Besides lending money at exorbitant interest rates to small businesses that traditional banks won't touch, most BDCs also offer "mezzanine" financing.

That's an arrangement which allows them to convert their debt capital to an equity stake in a successful small business. Or the BDC may be given warrants that allow them to buy stock at a specified price and time if the indebted company gains in value. BDCs also charge a fee for supplying business advisory services to the companies it invests in.

This revenue stream gives a BDC the ability to generate high current returns with the potential for robust future capital gains, a very attractive mix for investors.

But BDCs have always had these advantages. Why are they seeing interest from investors now?

First, while the credit crunch has eased, bank financing remains tight for small businesses. According to a recent Goldman Sachs report, "There is a lack of credit availability for small firms that rely mainly on bank credit." These firms need to turn to smaller lenders like BDCs for financing.

Mergers and acquisitions are also heating up due to increased confidence in the business community. This creates fertile soil for deal making and BDCs in particular. As Paul Parker, Head of Global Mergers and Acquisitions for Barclays Capital, predicts, "The next two quarters will probably be...a very aggressive period of speed dating where companies will try out different combinations to see if they make strategic sense."

BDCs thrive on merger mania, which boosts the capital gains potential of their existing equity stakes. And as the merger activity trickles downward to smaller companies, the need for financing from BDCs for buyouts and acquisitions should also increase.

And that should lead to higher yields, thanks to the laws surrounding business development companies.

As Registered Investment Corporations (RIC), BDCs must pay out at least 90% of their net investment income as dividends to shareholders to avoid paying corporate tax. That's why many of them carry double-digit yields, and the stronger the earnings, the higher the yields.

But things weren't always so good for BDCs. The financial crisis of 2008-2009 wreaked havoc with many of them. Some were forced to cut their distributions and have been slow to recover.

In searching for the best BDCs of the breed, you need to look for those with the best loan portfolios that are most likely to support the distributions entirely out of investment income. Evaluating the risk/reward profile of a BDC's portfolio is no easy matter, as credit rating agencies like Standard & Poor's don't slap a rating on most of the private companies that are held in BDC loan portfolios.

But some BDCs do take more risk than others. The key is to check out whether the loans are senior or subordinated, secured or non-secured, a first or second lien. Senior secured debt is the most secure because it's paid back first and the lender may seize assets if the loan defaults.

Of course, if a business development company does hold riskier assets, investors are typically rewarded with higher yields. In the current improving business environment, this type of BDC could prove the most lucrative.

-- Carla Pasternak
Editor
High-Yield Investing
High-Yield International