BDC Dividends and Pass-Through Status: High Yields, High Stakes

Business Development Companies routinely yield 8-14%—four to seven times the S&P 500's dividend yield. That's not a typo. These pass-through entities lend to middle-market companies too small for Wall Street attention, collecting interest spreads that flow to shareholders. But those yields come with mandatory 90% distribution requirements that leave little cushion, ordinary income taxation at rates up to 37%, and credit cycle sensitivity that crushed BDC dividends during 2008-2009 and 2020. The practical opportunity isn't chasing the highest yield—it's understanding the regulatory structure that creates BDC yields and the economic risks that threaten them.

What BDCs Actually Do (The Business Model)

BDCs are essentially publicly traded private equity lenders. They provide financing to middle-market companies (typically $10 million to $500 million in annual revenue) that can't access traditional bank loans or public bond markets.

The capital structure:

BDC structure → Regulated Investment Company (RIC) status → Pass-through taxation → Must distribute 90%+ of income

Congress created BDCs in 1980 to channel capital to smaller businesses. The incentive? Tax advantages similar to REITs—skip corporate taxation if you pass through income to shareholders.

How BDCs generate income:

1. First lien loans — Senior secured debt, first in line during bankruptcy
2. Second lien loans — Junior debt, higher yields, more risk
3. Mezzanine debt — Subordinated loans, often with equity kickers
4. Equity investments — Minority stakes providing upside participation

The typical BDC portfolio yields 10-13% on its investments. After operating expenses and leverage costs, shareholders receive 8-12% distribution yields.

The 90% Rule (Pass-Through Mechanics)

BDCs elect Regulated Investment Company (RIC) status under Subchapter M of the Internal Revenue Code—the same tax framework governing mutual funds. This creates the distribution mandate.

RIC requirements for BDCs:

1. Distribute 90% of investment company taxable income (ICTI) annually
2. Derive 90%+ of gross income from investment activities (interest, dividends, gains)
3. Diversification tests — No single investment exceeds 25% of assets
4. Asset composition tests — At least 50% in qualified securities

The practical reality: Most BDCs distribute 98% of ICTI to avoid all corporate-level taxation. The 2% buffer covers timing differences, not strategic retention.

Why this matters to you:

Limited flexibility chain: Mandatory distribution → No retained earnings buffer → Vulnerable to credit cycle → Dividend cuts during recessions

Unlike regular corporations that can cut dividends and retain cash, BDCs must distribute almost everything. When credit losses spike, dividends get cut—there's no cushion.

Tax Treatment (Ordinary Income Reality)

Here's the uncomfortable truth: BDC dividends are overwhelmingly taxed as ordinary income, not qualified dividends.

Why BDC income doesn't qualify:

BDCs earn interest income (from loans) and pass it through. Interest is taxed as ordinary income at the corporate level—and that character passes through to you. The RIC structure doesn't convert interest into qualified dividends.

Typical BDC distribution breakdown:

• Ordinary income: 70-90% (taxed at your marginal rate)
• Capital gains: 5-20% (taxed at 0/15/20%)
• Return of capital: 0-15% (tax-deferred, reduces basis)

The tax math:

$10,000 BDC position yielding 10% = $1,000 annual income

In taxable account (24% bracket):

• Tax: ~$1,000 × 24% × 85% (assuming 85% ordinary) = $204
• Plus capital gains tax on remainder
• After-tax yield: roughly 7.9%

In Roth IRA:

• Tax: $0
• After-tax yield: 10%

Annual tax drag: 2.1% on yield (21% of income)

The durable lesson: BDC headline yields overstate after-tax returns in taxable accounts. Account placement matters more here than almost any other income investment.

Credit Risk (The Cycle Sensitivity)

BDCs lend to companies that banks won't touch. That's the source of high yields—and the source of risk.

Credit cycle impact:

During recessions, middle-market companies default at higher rates than large-cap corporations. BDC portfolios experience:

• Rising non-accruals (loans not paying interest)
• NAV declines from write-downs
• Dividend cuts to preserve capital
• Share price drops exceeding NAV declines

The 2008-2009 lesson:

Many BDCs cut dividends 30-50% during the financial crisis. Share prices fell 60-80%. Investors who bought for yield experienced both income cuts and capital losses simultaneously.

The 2020 stress test:

The COVID panic triggered similar (though briefer) stress. BDCs with heavy exposure to retail, hospitality, and energy faced immediate non-accrual spikes. Quick Fed intervention prevented prolonged damage, but the vulnerability was clear.

The causal chain: Economic stress → Borrower defaults → Non-accrual income → Lower NII → Dividend cuts → Price decline

Evaluating BDC Quality (What Separates Good from Bad)

Not all BDCs carry equal risk. These metrics separate sustainable yield from yield traps.

Net Investment Income (NII) Coverage

The key metric: Does NII cover the regular dividend?

NII calculation: Interest Income - Operating Expenses - Interest Costs = Net Investment Income

Coverage benchmarks:

• Above 110%: Healthy buffer
• 100-110%: Tight, monitor closely
• Below 100%: Dividend at risk (supplemented by capital gains or return of capital)

The red flag: BDCs paying dividends exceeding NII are distributing capital, not income. This erodes NAV over time.

Portfolio Quality Indicators

• First lien percentage: Higher is safer (70%+ preferred)
• Non-accrual rate: Below 2% of portfolio is healthy
• Average portfolio yield: If much higher than peers, why?
• Concentration: Top 10 positions should be <30% of portfolio

Leverage and Funding

• Debt-to-equity ratio: Below 1.0x is conservative; 1.5x is maximum permitted
• Interest coverage: NII should cover interest expense 2x+
• Funding mix: Secured vs. unsecured debt, fixed vs. floating rates

NAV Trend

Watch the direction: Consistently declining NAV signals credit losses exceeding income. A BDC paying 10% yield while NAV drops 5% annually isn't generating 10% returns—it's returning your capital.

Implementation Considerations

Individual BDCs vs. BDC ETFs

Individual BDCs:

• Higher yields (no ETF management fee drag)
• Company-specific risk
• Requires credit analysis capability
• Wide bid-ask spreads on smaller BDCs

BDC ETFs (e.g., BIZD):

• Diversification across 20-40 BDCs
• Lower yields (expense ratio + blended quality)
• Easier due diligence
• Daily liquidity

The tradeoff: ETFs reduce company-specific risk but include troubled BDCs you'd avoid individually. The best BDC investors pick individual names; diversified income seekers use ETFs.

Account Placement (Non-Negotiable)

Given ordinary income taxation, tax-advantaged accounts are strongly preferred:

The exception: If you're in the 10-12% bracket and need current income, taxable accounts become acceptable. But understand you're giving up 10-12% of every dollar in taxes.

Position Sizing

Rule of thumb: BDCs shouldn't exceed 5-10% of your income allocation due to:

• Credit cycle correlation with broader market stress
• Dividend cut risk during recessions
• NAV volatility

Diversifying BDC exposure across 3-5 names (or one ETF) further reduces single-company risk.

Warning Signs Checklist

Immediate Red Flags

• NII coverage below 100% — Dividend exceeds earnings
• Non-accruals above 3% — Credit problems emerging
• NAV declining 3+ consecutive quarters — Portfolio deteriorating
• Yield significantly above peers — Why is market demanding premium?

Yellow Flags (Investigate Further)

• Special dividends making up large share of total — Unsustainable
• Heavy second lien/mezzanine exposure — Higher loss rates in downturn
• Concentrated portfolio — Single sector or borrower risk
• External management — Potential conflicts of interest

Sector-Specific Concerns

• Energy exposure — Volatile commodity prices
• Retail exposure — E-commerce disruption
• Healthcare services — Regulatory and reimbursement risk

The BDC Value Proposition (When They Make Sense)

BDCs fit specific portfolio needs:

Good fit:

• Tax-advantaged accounts seeking high current income
• Investors comfortable with credit cycle volatility
• Portfolios lacking private credit exposure
• Income needs that justify accepting ordinary income taxation

Poor fit:

• Taxable accounts in high tax brackets
• Investors who will panic-sell during credit stress
• Portfolios already heavy in high-yield bonds or leveraged loans
• Principal preservation priorities

The test: Can you hold through a 2008-style BDC drawdown (40-60% price decline, 30-50% dividend cut) without selling at the bottom? If not, the high yield won't compensate for behavioral mistakes.

Next Step (Put This Into Practice)

Check the NII coverage ratio for any BDC you own or are considering.

How to find it:

1. Go to the BDC's investor relations page
2. Find the most recent quarterly earnings release
3. Locate "Net Investment Income per share"
4. Divide annual NII by annual regular dividend per share

Interpretation:

• Above 110%: Healthy buffer for credit deterioration
• 100-110%: Dividend covered but no margin of safety
• Below 100%: Dividend at risk—investigate immediately

Action: If NII coverage is below 110%, examine the non-accrual rate and NAV trend. Multiple warning signs together suggest dividend cut risk is elevated.

References

• Grant Thornton. "Business Development Companies: Understanding Tax-Related Opportunities." 2017.
• Internal Revenue Service. "Regulated Investment Companies." Subchapter M, IRC.
• Fitch Ratings. "BDC Sector Update." 2024.
• S&P Global. "BDC Rating Methodology." 2024.