The Federal Reserve is widely expected to slash interest rates this month and to make additional cuts in the months to come. In fact, the market thinks that there is a greater than 50% probability of the Fed cutting by 125 basis points by the end of the year. This is a significant reduction in interest rates for a mere four-month period, which could have a substantial impact on securities whose yields are tied to short-term interest rates. As a result, the business development company (i.e., BDC) sector is particularly at risk, as many BDCs are set to face reductions of over 10% in their net investment income should the Fed cut rates by 100 basis points.

With this in mind, we will take a look at the VanEck BDC Income ETF (NYSEARCA:BIZD) to determine if rate cuts are likely to provide a meaningful headwind for it.

BIZD Holdings

Before digging into the rate cuts, we need to look at the top holdings in BIZD. A brief look at its top 10 holdings reveals that the fund is largely dominated by Ares Capital Corporation (ARCC), with 21.52% of its portfolio allocated to this BDC. Overall, despite having 26 total positions, the top 10 holdings make up 72.41% of the ETF. This makes it very top-heavy, with FS KKR Capital Corporation (FSK) taking up another 9.42%, Blue Owl Capital Corporation (OBDC) taking up 9.1%, Blackstone Secured Lending Fund (BXSL) taking up 8.26%, and Main Street Capital Corporation (MAIN) rounding out the top five with 4.81% exposure. Its other top holdings include Hercules Capital (HTGC) at 4.56%, Golub Capital (GBDC) at 4.46%, Sixth Street Specialty Lending (TSLX) at 3.91%, Morgan Stanley Direct Lending Fund (MSDL) at 3.19%, and Prospect Capital Corporation (PSEC) rounding out the top ten with 3.17% exposure.

Rate Cut Impacts

To determine the impact that rate cuts will have on this ETF, we need to look at the interest rate sensitivities of these firms based on the current interest rate sensitivities reported in their respective 10-Qs. Ares Capital Corporation will see a 7.5% headwind to net investment income for every 100 basis points that the Federal Reserve cuts. FS KKR Capital Corporation will experience a similar effect, with a 7.5% reduction in net investment income for every 100 basis points that the Fed cuts rates. Blue Owl Capital Corporation has a bit more interest rate exposure, with its net investment income likely to decline by about 9% for every 100 basis points that the Fed cuts. Blackstone Secured Lending Fund faces even greater headwinds from interest rate cuts, with an 11.5% reduction for every 100 basis points. Main Street Capital Corporation will see its net investment income decline by just 4.3%, while Hercules Capital will experience a headwind of 5.8% for every 100 basis points the Fed cuts. Golub Capital BDC will see an 11.5% headwind, and Morgan Stanley Direct Lending Fund will face an 11.3% reduction. Sixth Street Specialty Lending will experience a 6% hit, and Prospect Capital will see an 8.6% decline in net investment income from a 100 basis point cut.

What this shows is that while there are a few firms — such as MAIN, HTGC, and TSLX — that will not see a significant headwind from interest rate cuts, many of them will experience a meaningful impact. As a result, while rate cuts should help stabilize the performance of underlying loans by reducing pressures on the balance sheets of BDC counterparties, thereby reducing non-accruals, they will still present a material headwind to the funds' underlying holdings' earnings power. Additionally, it is likely to reduce supplemental distributions from these BDCs and potentially even threaten some of their regular dividends.

However, ARCC, FSK, OBDC, BXSL, MAIN, HTGC, GBDC, TSLX, and MSDL all have sufficient coverage of their regular dividends that a mere 100 basis point or even 125 basis point cut by the Fed is unlikely to threaten their regular dividends. Nevertheless, if rate cuts become much deeper next year, especially if accompanied by a recession, some of these dividends may begin to be challenged. The only one out of the top ten that is at risk of a material dividend cut in the near term is Prospect Capital (PSEC), which makes up 3.17% of the overall portfolio.

Investor Takeaway

In conclusion, BIZD is not overly threatened by at least a mild set of Federal Reserve rate cuts. That said, its total dividend payouts will likely decline due to a reduction in the special distributions from its underlying holdings moving forward as dividend cuts begin to impact their net investment income levels. Therefore, investors who hold BIZD should expect a lower dividend yield going forward. Additionally, if rate cuts become much deeper and/or a recession hits, BIZD will probably suffer a loss of NAV due to a decline in its underlying BDCs' valuations, and/or a decrease in their underlying net asset values. Thus, while the initial wave of dividend cuts is only a minor headwind and should not be viewed as a significant threat, material interest rate cuts and/or an economic downturn would be very bad news indeed for BIZD.

As a result, we think it is prudent to underweight the BDC sector, including a stake in BIZD, for the foreseeable future until more clarity is gained into macroeconomic conditions. This is especially true given that the BDC sector is fairly richly valued right now, with many BDCs — such as ARCC, MAIN, and others — trading at premiums to both their underlying NAVs and their historical valuation averages.