After Being Left for Dead, These High-Yield Stocks Look to Rally Again. Here's How to Play It.

The market segment focused on business development companies (BDCs) and the VanEck BDC Income ETF (BIZD) are experiencing renewed interest. While BIZD faced a significant loss in the first half of the year, a positive trend is emerging. However, there are notable risks that could resurface at any moment. The ETF's top holding, Ares Capital (ARCC), comprises 14% of its assets, reflecting the market's apprehension towards illiquidity, leading to strong demand from investors seeking to withdraw funds from these private partnerships.

BIZD remains a $1.7 billion ETF, which is relatively inexpensive compared to the broader stock market, trading at 10x trailing earnings. Additionally, the ETF boasts a five-year beta of only 0.64, indicating its steady nature as a high-income investment. Currently, BIZD yields around 11%, making it nearly three times more lucrative than the S&P 500's upper single-stock yields.

BDCs operate as closed-end funds, providing direct financing to small-to-mid-sized businesses through private debt. Recently, investors' concerns about potential defaults and liquidity issues have caused BIZD to lose some of its value. Despite this, the ETF is showing promising signs of recovery, primarily due to BDCs' ability to generate higher dividend yields, often exceeding 9% to 10%, compared to traditional listed stocks.

BDCs generate income by borrowing at fixed rates or long-term credit facilities and then lending it to private middle-market companies at floating rates tied to short-term benchmarks. This enables BDCs to capture a yield spread, distributing most of their taxable income back to shareholders while maintaining their tax-exempt status.

Furthermore, BDCs primarily hold first-lien senior secured debt, placing them at the top of the capital structure in case of default or restructuring, making them a less risky investment than common stocks of the same companies.

However, there are still concerns regarding credit quality degradation, such as the potential for economic slowdown to hinder weaker middle-market borrowers from servicing their floating-rate debt, leading to an increase in non-accrual loans. Additionally, prepayment risk arises as central bank rate cuts reduce the interest income generated by floating-rate loan portfolios, narrowing BDC dividend coverage ratios.

In summary, BIZD is a high-risk, high-reward investment opportunity currently trading between $12 and $15. Breaking even at this price point means capitalizing on the ETF's attractive yield, which is a significant advantage for equity investors.