On Tuesday, my colleague David Sterman proclaimed the end of the rally. In effect, his main point is that while bonds have been a source of safety recently (while also performing very well), there's just not that much upside left to be had. He also said -- and this is really important -- that at this point investors would be far better off owning shares of solid companies that consistently raise dividend payouts over time.
I couldn't agree more.
In fact, yield-hungry investors can find rich dividend yields of 10%, 11% and even higher in a little-known corner of the stock market.
I'm talking about business development companies (BDCs).
These companies act like venture capital firms by lending to smaller businesses that need funding for growth and other initiatives. In exchange, many BDCs will not only earn interest for funding these companies, but they'll often get an equity stake in the company as part of the arrangement.
The great thing for investors is that they can get exposure to this important part of the business world through the liquidity of a publicly-traded stock. [My colleague, Amy Calistri, also loves BDCs. In fact, it's one of the ways she earned $1,357.52 in dividends in one month using her Daily Paycheck strategy.]
Only a handful of stock analysts follow BDCs and you won't find any of these companies in the S&P 500 Index. But despite their obscurity, BDCs can be great income investments for those who understand them.
Yields are high because, as regulated investment companies, BDCs are required to pay out at least 90% of their profits to investors. BDCs are also prohibited from taking on too much debt leverage.
For investors who are just starting out, BDCs can seem a bit intimidating because of their complex financials. But I think their generous dividend payouts make them well worth considering. Here are my rules in selecting the safest and most profitable BDCs...
Rule No. 2: Portfolio yields should exceed borrowing costs of funds. The difference between these two determines BDC profits.
Rule No. 3: Senior debt should dominate the portfolio. Senior debt is the safest because it's the first debt to be repaid if the borrower gets into trouble.
Rule No. 4: Leverage should be moderate. Less debt is better because low-leverage BDCs are better able to weather industry downturns.
With these rules in mind, I found three high-yielding BDCs that look quite appealing right now...
1. Prospect Capital Corp. (Nasdaq: PSEC)
Prospect has recorded five straight quarters of double-digit earnings growth and generated net investment income totaling $1.10 per share during the first nine months of fiscal 2012 ending in June. Net investment income more than covered its $0.91 of dividends per share in the period. Prospect has an excellent track record of dividend coverage and has produced net investment income exceeding dividends every year since the company's IPO nearly eight years ago.
Prospect earned a 12.8% yield on its investment portfolio in fiscal 2011 and has produced yields averaging 13.6% for the past three years. These yields compare very favorably to weighted average borrowing costs of only 5.6%. Prospect has been generating 7.0% profit margins, which provide plenty of cash to grow dividends.
The company ended fiscal 2011 with senior secured debt of $823 million, which represented 55% of the portfolio. This percentage is not as high as I would have liked, but it's a step in the right direction compared with the previous year, when senior secured debt was $314 million and only 39% of the portfolio.
2. Ares Capital (Nasdaq: ARCC)
Ares is among the industry's oldest and largest BDCs, with a portfolio value that currently exceeds $5.2 billion. Large BDCs are often preferable, because they have the scale necessary to easily absorb administrative costs.
Ares improved its net investment income by 31% last year to $282.4 million. Earnings per share of $1.56 in 2011 more than covered the $1.41 per share dividend, but net investment income per share fell slightly short of expectations at $1.38 per share. Dividend coverage for Ares has not been consistent, although net investment income has exceeded dividends in three of the past five years.
The investment portfolio yielded 12% last year and 12.5% in the past three years. With weighted average borrowing costs of only 5.1% last year, Ares was able to generate a very respectable 6.9% profit margin.
Ares earns high scores for the safety of its investment portfolio. The company holds $4.3 billion of senior debt, which represents roughly 84% of the portfolio. Leverage is a bit high with debt at $2.1 billion and a 69% debt-to-equity ratio, but still well below the one-to-one maximum ratio allowed for BDCs.
3. Triangle Capital Corp. (Nasdaq: TCAP)
Triangle invests across a variety of business sectors, but has a geographic focus on the Southeast and Mid-Atlantic states. Triangle generated net investment income per share of $2.06 in 2011, which was up 30% from $1.58 in the prior year and more than enough to cover 2011 dividends of $1.77 per share. In the past three years, Triangle has produced cumulative net investment income that covered 105% of dividend payments.
Triangle's investment portfolio yield was the best of the three BDCs last year at 13.9%, and has averaged 13.7% in the past three years. The company's borrowing costs were also below average last year at 4.5%, which gave Triangle a healthy 9.4% profit margin.
This company's portfolio is a bit riskier than the other two, however. Senior and first-lien debt totaled $61 million and just 12% of the portfolio. Triangle holds mostly subordinated debt, which at $394 million accounted for 79% of the portfolio. Long-term borrowings are $239 million and give this company a somewhat high debt-to-equity ratio at 69%.
Risks to Consider: BDC dividends are generally taxed as ordinary income, so these stocks are best held in a tax-deferred account. In addition, these stocks are very sensitive to interest-rate swings and can be volatile. Dividends can fluctuate as well and several BDCs were forced to reduce their dividends during the financial crisis.
Action to Take --> My top pick overall is Prospect Capital Corp. because it has the best track record of dividend coverage and the best balance sheet. Ares and Triangle are both profitable and pay generous dividends, though the former has a higher percentage of senior debt, which I prefer.
[Note: BDCs are just one of the many income investments Amy uses to collect regular, monthly dividend paychecks. To learn more about how Amy used this strategy to collect $1,357.52 in income in one month, go here (you won't have to sit through a long video).]