After years of soft interest rates, investors are slowly being confronted by a firmer rate environment. This clearly shows in the market’s fear gauge, the CBOE Volatility Index’s recent six-month high. Further, the S&P 500 plummeted 10% before picking up.  And with the Fed intent on raising rates this month, things will only get tougher for equity markets.

However, it isn’t that rates are detrimental for stocks of all classes. One class of companies which gains when rates rise is business development corporations (BDCs). Not only do BDCs pay out an average dividend of nearly 10%, they also act as a buffer against rising rates. This is why they would make great additions to your portfolios at this point in time.

Why Do Rising Rates Drag Down Stocks?

The Federal Reserve has raised rates thrice this year and is set to announce another hike in December. The yield on the 10-year Treasury bond has increased by more than 100% since 2016 and recently hit a seven-year peak. Firmer rates are in the end the outcome of a booming economy. Under such circumstances, rates can only go up.

For years, investors and companies have become used to a soft interest rate regime. Corporations have borrowed on the cheap, enabling them to finance their expansion at low costs. However, they are now faced with a spike in rates. This makes it tough to finance operations and service existing debt.

This is why higher rates push down company earnings and ultimately drag share prices lower. Ultimately, this has a widespread impact on broader equity markets. Per a study by Bridgeway Capital Management, the long-term average gain of the S&P 500 in a soft rate regime is 13.3%. However, when rates climb, this return is slashed by nearly half.

Why BDCs Prosper When Rates Climb

BDCs usually invest in privately held small to mid-sized businesses. Companies suffering from financial distress are their primary targets. In a sense, they are similar to venture capital funds, which are open only to institutional investors.

Further, BDCs are structured in such a way that they pay nearly nothing in terms of corporate income taxes. Instead, they pay out nearly 90% of their taxable income to shareholders as dividends. In reality, they could distribute nearly 98% of their taxable income, which could result in dividend yields of 10% or more. 

BDCs also act as a hedge against rate increases. The reason that they prosper in such an environment is that conventional loans become tougher to secure. This is because banks firm up their lending norms when the cost of capital increases.

Further, they finance loans with stiff interest rates to small and middle-market companies. In the absence of BDCs, such companies would be unable to secure such loans. And, they usually pay rates of around 10% to service these loans.

Our Choices

As the economy goes from strength to strength, rates will only scale higher. In such an environment, BDC income will rise as they finance more high-yield deals for small and mid-sized companies. This is particularly true for BDCs with a large amount of floating-rate loans.

Investing in BDCs looks like a smart option at this point. We have narrowed our search to the following stocks based on a good Zacks Rank and other relevant metrics.

Prospect Capital Corporation (PSEC - Free Report) is a business development company. It lends to and invests in private and microcap public businesses.

Prospect Capital’s expected earnings growth for the current year is 20.3%. The Zacks Consensus Estimate for the current year has improved by 11.8% over the last 30 days. The stock has a dividend yield of 10.6%. It sports a Zacks Rank #1 (Strong Buy). 

Stellus Capital Investment Corporation (SCM - Free Report) is a business development company focusing on investing in privately-held middle market companies.

Stellus Capital Investment has a Zacks Rank #2 (Buy). The company has expected earnings growth of 6.8% for the current year. The Zacks Consensus Estimate for the current year has improved by 1.4% over the last 30 days. The stock has a dividend yield of 10%.

New Mountain Finance Corporation (NMFC - Free Report) is a business development company specializing in investments in middle market companies and debt securities at various levels of the capital structure.

New Mountain Finance has a Zacks Rank #2. The company has expected earnings growth of 7% for the current year. The Zacks Consensus Estimate for the current year has improved by 0.5% over the last 30 days. The stock has a dividend yield of 10.1%.

OFS Capital Corporation (OFS - Free Report) is a business development company focusing on direct and fund investments.

OFS Capital has a Zacks Rank #2. The company has expected earnings growth of 3.5% for the current year. The Zacks Consensus Estimate for the current year has improved by 1.1% over the last 30 days. The stock has a dividend yield of 12.1%.

Ares Capital Corporation (ARCC - Free Report) is a business development company. It invests primarily in first and second lien senior loans and mezzanine debt, which in some cases includes an equity component, and, to a lesser extent, in equity investments in private U.S. middle market companies.

Ares Capital has a Zacks Rank #2. The company has expected earnings growth of 16.9% for the current year. The Zacks Consensus Estimate for the current year has improved by 0.4% over the last 30 days. The stock has a dividend yield of 9.2%.