Volatility is back.
Last week, the CBOE Volatility Index (VIX)—also known as the Fear Index—hit its highest level in six months.
This was after the S&P 500 lost 10% in 30 days.
The reason for the falling stock market: rising interest rates.
Interest Rates Have a Long Way to Go from Here
The Federal Reserve has raised interest rates three times this year. Most expect the Fed to hike rates one more time by the end of the year.
Since 2016, the yield on the 10-year Treasury bond has more than doubled. In fact, the yield hit 3.2% last week —its highest level since July 2011.
Central banks raise interest rates when the economy is strong. And the US economy is currently firing on all cylinders.
At this point, it looks like rates have nowhere to go but up.
Higher Rates Are Bad News for Stocks
When interest rates rise or fall, the effect will ripple through the economy.
When rates are low, it’s cheaper for businesses to borrow money.
But when rates climb higher, the opposite is true. It’s more expensive to run a company and to carry its existing debt.
That, in turn, will lower company earnings and weighs on share prices. Eventually, the fallout hits the broader markets.
A study from Bridgeway Capital Management showed that after interest rates fall, the long-term average return on the S&P 500 is 13.3%.
In periods when interest rates are climbing, the return on the S&P 500 is almost half that figure.
But all businesses are not negatively affected by rising interest rates. In fact, some businesses actually benefit when interest rates rise.
One type of business that fits this bill is business development corporations, also known as BDCs.
BDCs Can Protect Your Portfolio from Rising Interest Rates
BDCs are companies that invest in small to medium-sized private businesses. The investments are often made in companies that are financially distressed.
BDCs are similar to venture capital funds, which are typically only open to institutional investors.
The structure of BDCs means they pay almost no corporate income taxes. Instead, they distribute at least 90% of their taxable income as dividends to shareholders.
Actually, most BDCs pay out 98% of their taxable income.
For BDC investors, that can mean a dividend yield of 10% or higher.
And if you find the right BDC, it can also act as a hedge against rising interest rates.
Fewer Banks Is a Major Opportunity for BDCs
One big reason why BDCs benefit from rising rates is that it’s harder to secure conventional bank loans when rates are higher.
Loan underwriters for banks hold companies to stricter standards since the cost of capital is higher.
There’s another reason: The number of US banks has shrunk by 46% since 1998.
Since there are fewer banks with a smaller pool of capital, they make less risky loans. In 1994, banks held 71% of these riskier loans—also known as high-yield loans. That figure is down to just 9% today.
BDCs have moved in to fill this gap left by traditional banks.
The thing is, BDCs can finance high-yield deals with small- and middle-market companies. Without BDCs, these companies would not have access to the types of loans they need to expand.
And these smaller companies must pay a handsome fee for loans. Interest rates are typically in the 10% range.
That’s more than four times the average stock dividend and twice the yield on junk bonds.
Despite the high interest rate, these companies are clamoring for BDC capital.
In 2010, the entire BDC market was valued at $18 billion.
Today, that figure tops $45 billion.
And as interest rates rise, BDCs will be in even higher demand.
The Secret Behind the Success of BDCs
These aren’t the only reasons why BDCs love higher rates.
Unlike most traditional bank loans, BDC loans have a floating rate. As rates rise, so do the rates on BDC loans.
The floating rates are almost always pegged to the 10-year US Treasury bond.
As the US economy chugs along and rates rise, BDCs will see their interest income rise, too. This is especially true for BDCs that have a large portfolio of floating-rate loans.
You Won’t Regret Adding a BDC to Your Portfolio
There are four BDCs that I really like, and one of them is in the Yield Shark portfolio.
The other three are TCG BDC Inc. (CGBD), PennantPark Floating Rate Capital Ltd. (PFLT), and BlackRock TCP Capital Corp. (TCPC).
While these are all solid companies, the one I recommended to my subscribers has over 95% of its portfolio in floating-rate loans. It also has a stable 7.5% dividend yield.
Either way, as the economy keeps rolling and rates keep rising, you need companies in your portfolio that will benefit from this trend.
And BDCs are the best way to do that.