The stock market is heading into its sixth year of this bull run, and investors are getting increasingly skittish with each sell-off. With the threat of higher interest rates in 2015, investors may be in for a rough ride. If you haven’t started thinking about diversifying your portfolio away from stocks, now would be a good time. 

But cash and fixed-income are earning next to nothing, and many of the “safe” asset classes carry interest rate risks. Fortunately, there is an alternative investment class that can help diversify your portfolio and should continue to benefit from a stronger economy and higher rates.

Diversify With BDCs

Business development corporations (BDCs) are special finance companies that invest and lend money to small- and medium-sized companies much the same way that a private equity firm operates. Strategies are pretty diverse from providing capital for buyouts and restructuring to lending money on a short-term basis for projects and securitization.

#-ad_banner-#

BDCs are a good diversifier for a portfolio of shares in regular corporations because of their diversified financial investments. The UBS ETRACS Wells Fargo Business Development Corporation ETN (NYSE: BDCS) shows a correlation of 0.67 with the S&P 500 over the past three years. That means that only about two-thirds of the movement in the shares has related to general stock market pressures.

Most of these companies pay out much of their earnings in dividends with yields in the double digits. A lot of investors are attracted to the regular cash flow, with some BDCs even offering monthly payouts. 

But the BDC that tops my list hasn’t paid a dividend since 2008. However, it has been returning cash to shareholders with an aggressive stock buyback program, retiring 29% of its shares outstanding since 2011.

Besides its BDC business model offering the opportunity for diversification, this company has a strong catalyst for growth coming next year.

American Capital (NASDAQ: ACAS) invests up to $750 million in small- and medium-sized companies through senior debt, mezzanine debt and a variety of equity and recapitalization strategies. The company was once the largest business development corporation, but it got caught in the 2008 financial crisis. It has clawed its way back to $80 billion in assets though it has yet to reinstate its quarterly dividend. 

The company is one of the most efficiently run among its peers with operating costs of just 2.8% as a percentage of net asset value (NAV), the lowest among the top five BDCs. The stock also provides an even better diversifier against the stock market. Over the past three years, shares of ACAS have had a correlation of just 0.57 with the stocks in the S&P 500. 

What interests me most about American Capital, though, is a strong catalyst announced during the third-quarter presentation. The Board of Directors has approved a plan to split the company into three businesses. American Capital will become a regular C-corporation, retaining all employees and will manage the spin-off companies. American Capital Growth & Income and American Capital Income will remain BDCs and use different investment strategies. 

The separation into three businesses will drive greater transparency and allow the market to value each distinct investment strategy. This could help improve capital raising by making a simpler structure and reducing the perceived conflict between buyouts and sponsored finance. Beyond the structural opportunities, the two BDCs will begin returning cash to shareholders through distributions.

Collecting Cash Ahead of the Spin-off

It could take a couple of quarters to get regulatory approval for the spin-off and new corporate structures, but investors can start collecting a regular cash payout early with a covered call strategy.

With ACAS trading near $14.28 at the time of this writing, we can buy 100 shares and simultaneously sell an ACAS Feb 15 Call, which is trading around $0.42 ($42 per contract). This gives us a net cost of $13.86 per share, which is 3% below current prices

If ACAS is above the $15 strike price at expiration on Feb. 20, our shares will be sold for that price. In this case, we will make a $1.14 per-share profit, or 8.2%, in just 68 days. If we were able to make a similar trade every 68 days, we could earn a 44% rate of return in a year.

I like the trade as long as we can get in for a net cost of $14.15 or less, which still leaves us with a gain of 6% and a good discount to the current price. 

If ACAS is below $15 on expiration, we keep the shares and the option premium. We’ll then have the opportunity to sell another call against the shares to generate more income and lower our cost basis further.

I like the shares as part of a hedge against stock and bond market weakness on higher rates. Much of the company’s debt portfolio is relatively short maturity, so higher rates should not decrease their value too much, and the rising rate environment will help drive interest income for new debt. 

The spin-off of American Capital Income is anticipated to be a taxable event, though investors should enjoy some tax-deferment with the spin-off of American Capital Growth & Income shares. Your own tax situation may dictate whether you stick with the shares through the spin-off, but that still leaves much of 2015 to benefit from a covered call strategy.

Note: For the past year, my colleague Amber Hestla has been using this strategy with stunning results. She has a 90% success rate and is producing average annualized gains of 86% per trade. Click here to get the next trade.

This article was originally published on ProfitableTrading.com: The Alternative Income Investment That Could Yield 44% A Year​