Fifth Street Finance Corp. Is Your Chance to Buy a 10.8% Dividend at a Discount

It's rare to find a company with a high, sustainable yield trading at a discount to the assets it owns.

Jun 3, 2014 at 9:07PM

Fifth Street Finance Corp. (NASDAQ:FSC) is a business development company (BDC) that mainly lends to and invests in small and medium-sized companies. Despite its diversity, stable monthly dividend payments, and excellent yield, shares are actually trading at very nice discount.

Fifth Street Finance could be an excellent way to achieve high income in your portfolio with significant upside potential.

Why Fifth Street Finance?
Fifth Street Finance loans out its own capital and borrows additional money to lend to businesses at higher rates than it borrows for. As an example, the company recently issued $250 million of five-year unsecured notes at a fixed coupon rate of 4.875%. Meanwhile, the company's average return on its debt investments is 10.8%.

Don't worry too much about the possibility of rising rates hurting Fifth Street Finance's profit margins. About 74% of the company's portfolio of debt investments is at floating interest rates, meaning if rates go up, so does Fifth Street's income stream.

How can it pay so much?
As a regulated investment company (RIC), one of Fifth Street Finance's requirements is to pay out at least 90% of its taxable income to shareholders each year. In doing so, the company does not get taxed on its investment income or capital gains.

Instead, the tax liability is passed on to the shareholders. Fifth Street Finance's dividend is not a "qualified dividend", and is not eligible for the qualified dividend tax rate, and is taxed as ordinary income. So, if you hold the shares in an ordinary brokerage account, you could take a hit during tax-time. However, if you hold your shares in an IRA, you won't have to worry about this problem.

Safety in diversity
When a company pays a dividend as high as Fifth Street Financial does, it's only natural to question the safety and sustainability of the payments. While it's true that many of the companies Fifth Street Finance invests in are not of excellent credit quality, the company's assets are extremely diversified and are therefore not terribly dependent on any one company's debt payments.

As of the most recent data available, Fifth Street Finance holds investments in 124 companies, with about 95% of the total portfolio in the form of debt such as senior secured loans. The average amount of debt held per company is about $25 million. So, if any one company defaults on their obligation to Fifth Street Finance, it would be unfortunate, but not devastating to shareholders.

The number to watch
A good target price for Fifth Street would be its net asset value, which stood at $9.81 per share as of the last quarterly report. This would represent a gain of about 6% over the current share price, and while you're waiting, the stock pays you pretty well to wait.

Also consider the benefits of monthly dividends when deciding on investments such as Fifth Street Finance. Monthly payments mean your returns compound more frequently than with other stocks which typically pay quarterly. A 10.8% annual dividend when paid monthly produces an effective annual yield of closer to 11.4%. Not an enormous difference, but enough to take into account when making decisions.

In summary, Fifth Street Finance may be a little riskier than say, investing in corporate bonds, but shareholders are more than compensated for the risk they take. It's rare that you can find a high-paying stock with a safe dividend trading at a discount, and I'd be willing to bet Fifth Street Finance won't be on sale forever.

Is this a better investment than BDCs?
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That’s beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor’s portfolio. To see our free report on these stocks, just click here now.

Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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