Business Development Companies (BDCs) are firms that give loans to small and mid-sized companies at relatively higher rates and often grab debt or equity stakes in those companies. BDCs dole out high and stable cash distribution while captivating the equity performance of the borrower.

U.S. law obliges BDCs to distribute more than 90% of their annual taxable income to shareholders. These stocks provide handsome yield and might be in focus as the Fed maintains its rate hike spree.

SBIC & Commercial Industry currently carries a Zacks Industry Rank #37%, which places it in the top 37% of more than 250 Zacks industries.The segment has gained about 8% past month, while it yields as high as 9.69% annually.

The space is undervalued too. The forward P/E ratio of the space is 7.57X against 19.02X P/E of the S&P 500-based ETF IVV. Historical dividend growth of the SBIC space is 6.67% versus 4.55% for the S&P 500. The debt-to-equity ratio for the space is 0.46X versus 0.63X held by the S&P 500. Against this backdrop, top-ranked stocks Saratoga Investment Corp (SAR Quick QuoteSAR - Free Report) , Crescent Capital BDC (CCAP Quick QuoteCCAP - Free Report) and Main Street Capital (MAIN Quick QuoteMAIN - Free Report) emerge as strong picks.

Inside July’s Fed Rate Hike

Notably, the Fed raised its benchmark interest rate by 0.25% on Wednesday, leaving room for more hikes this year. Short-term rates are now in the 5.25-5.50% range, the highest since March 2001. This marked the 11th increase since March 2022, and the Fed stated that future hikes would depend on the economy and financial developments. The decision was unanimous (read: Dow Jones ETFs Continue Winning Run as Rates at 2001 High).

"The process of getting inflation back down to 2% has a long way to go," Fed Chair Powell said in a press conference Wednesday, as quoted on Yahoo. Powell added that bringing down inflation "is likely to require a period of below-trend growth and some softening of labor market conditions."

How Is the Operating Environment for Business Development Firms?

With the Fed continuing to hike rates and the regional banks coming under a tight spot, small-sized firms have every reason to turn to business development companies to arrange for funding. Although second-quarter corporate transaction activities like M&A remain slower than recent history, it has gained momentum compared to the first quarter.

Direct lenders gain a significant share as 85% of new issue LBO financing in the United States was completed by direct lenders. Direct lending also continues to be increasingly active beyond the arena of the LBO market as direct lenders accomplished 1.5X as non-buyout financings as the broadly syndicated market during the second quarter, according to data by LCD, as quoted on the earnings transcript of Ares Capital (ARCC Quick QuoteARCC - Free Report) .

Despite companies coping with higher borrowing costs, credit quality has been stable, and inflation too has started cooling. In a rising rate environment, these companies can potentially generate higher interest income on their loan portfolios, which could boost their overall revenues.

BDCs can actively manage their portfolios to adapt to changing interest rate conditions. They might adjust the duration and composition of their investments to optimize their returns. Some BDCs may choose to diversify their investment strategies to include floating-rate loans or other assets that can benefit from rising interest rates.

ETFs in Focus

Against this backdrop, below we highlight a few business development ETFs like VanEck BDC Income ETF (BIZD Quick QuoteBIZD - Free Report) (up about 10% past month), ETRACS MarketVector Business Development Companies Liquid Index ETN (BDCZ Quick QuoteBDCZ - Free Report) (up 6.7% past month) and ETRACS Quarterly Pay 1.5x Leveraged MarketVector BDC Liquid Index ETN (BDCX Quick QuoteBDCX - Free Report) (up 9.9% past month).