The abundance of investing choices can be paralyzing. Stocks, exchange-traded funds, mutual funds and more await. But income investors looking for high yields could consider a relatively unknown segment of the stock market: business development companies. These stocks, called BDCs for short, have multiple potential benefits for income investors.

BDCs are essentially publicly traded investment firms.

The model generally involves placing debt and/or equity investments in other companies, which have to meet certain requirements. The BDC, in return, generates interest income, dividend income, or capital gains from their investments. These depend on how the target company performs and the structure of the deal from the BDC’s side.

BDCs can also profit by realizing investment gains on securities that are sold.

Learning About BDCs

These target companies tend to be smaller, and therefore unable to access public market funding themselves. The BDC provides this middle-market capability by issuing public securities to fund investments in the smaller companies.

Often, these target companies are in the midst of a turnaround or other redevelopment, which provides the BDC with a higher interest rate or equity position to take advantage of the situation.

The BDC must invest at least 70% of its assets in companies that are privately or publicly held at market capitalizations of $250 million or less. This ensures BDCs are providing funding to those that need it the most.

BDCs, therefore, operate in very much the same way as a private equity or leveraged buyout fund. The difference is BDCs are publicly-traded. In comparison, other funds are generally available to accredited investors only, and are private.

Key Considerations for Investors

The appeal of BDCs from an investor’s perspective is obvious: BDCs tend to offer extremely high dividend yields to shareholders, owed to their unique structure.

BDCs generally pay yields in excess of 5%, and in a lot of cases, yields are closer to 10%. Investors must be aware that certain BDCs have higher quality holdings than others, which will certainly impact the yield.

As with any other investment, proper due diligence must be done rather than simply chasing the highest dividend yield. In general, a higher yield will correspond to lower-quality holdings and  higher risks.

In addition to the sizable yields an investor can achieve with BDCs, there are some risk factors involved.

First, BDCs generally issue large amounts of debt to fund their investments. These debt issues are generally done at high interest rates often in junk status, meaning yields on this debt can easily be in the high single-digits. BDCs then take these proceeds and invest them at higher yields in companies that have no alternative financing sources. These yields are often in the double-digits. This creates a spread for the BDC, which it then uses to pay expenses and hopefully, generate a profit to pay its dividend.

This works very well when economic strength is persistent, but when a recession strikes, many of these portfolio companies tend to be unable to make their debt payments, which results in lower investment income for BDCs.

Interest Rates and Credit Risk

In addition, BDCs are sensitive to interest rates. Because debt is issued to fund investments, sharp movements in interest rates can have outsized impacts on BDCs’ ability to generate a favorable spread on their investments. This is particularly true when debt has a floating rate, meaning it moves up and down with some sort of benchmark. BDCs with higher percentages of equity investments rather than debt will be even more sensitive to fluctuations in interest rates. Equity investments do not generate the same level of interest income.

Finally, and perhaps the biggest risk to investors, is credit risk. BDCs exist primarily to lend money to small companies that cannot otherwise obtain funding. This means credit risk is much larger than it would be for a traditional bank, or other form of lender. This is where the quality of the portfolio comes into play. It also is why investors must do significant due diligence in the BDC’s underlying portfolio holdings before putting money to work in a BDC.

Taxation is a separate issue that investors should be aware of. BDC dividends are generally not classified as qualified, meaning they would be taxed at ordinary income rates, rather than the more favorable dividend rate. For certain investors this will not be an issue, but it is an important consideration for investors buying BDCs in a taxable account.

An Example of a Quality BDC

One example of a company that we like in the BDC space is Prospect Capital Corporation (NASDAQ:PSEC). Prospect is a BDC that has been public since 2004. It has a long track record and it has scale in a very fragmented industry, at a $3.3 billion market capitalization.

Today, the dividend payout is at $0.72 per share annualized. However, Prospect pays its dividend on a monthly basis, providing shareholders with a payout of $0.06 per share each month. This is a huge benefit for those looking to generate income to live off of, or those simply wishing to compound their wealth more quickly with more frequent dividend payments.

Prospect stock has rallied enormously in recent months, so the yield is lower than is typical for this particular BDC. Today, the stock yields 8.7%, but Prospect’s typical yield is more like 11% or 12%. Thus, we think investors should wait for a pullback before buying Prospect, but its current dividend looks stable for the foreseeable future.

And with a yield near 9%, Prospect’s dividend still towers above the average S&P 500 Index yield. For income purposes, Prospect stock looks quite strong.

Final Thoughts on BDCs

BDCs certainly aren’t for everyone, but for those investors that are looking for high yields, and in some cases monthly dividends, they can be a solid choice. There are certainly some risks and other issues to consider before buying, but solid BDCs like Prospect can generate yields many times that of the broader market.

Thus, for investors seeking to generate significant income, BDCs are worth a closer look.

On the date of publication, Bob Ciura did not have (either directly or indirectly) positions in any of the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Bob Ciura has worked at Sure Dividend since 2016. He oversees all content for Sure Dividend and its partner sites. Prior to joining Sure Dividend, Bob was an independent equity analyst. His articles have been published on major financial websites such as The Motley Fool, Seeking Alpha, Business Insider and more. Bob received a bachelor’s degree in Finance from DePaul University and an MBA with a concentration in investments from the University of Notre Dame.