High Yield Stocks for Dividend Investing: Prospect Capital Corporation

Source: Prospect Capital.

Income investors have struggled to squeeze more income from their investments, especially with low interest rates hurting cash flow from bonds and other fixed-income investments. Dividend stocks have played a vital role in delivering much-needed cash to investors, and Prospect Capital (PSEC 0.74%) has distinguished itself as one of the highest yielding stocks in the market. But skeptical investors wonder whether Prospect Capital's double-digit dividend yield is too good to be true.

Prospect Capital is a business development company, which is a special type of entity that invests largely in privately held companies either through equity investments or by providing financing as a lender. Business development companies get a key tax advantage in not having to pay taxes at the entity level, but the trade-off is that they have to pay out at least 90% of their income to their shareholders. As a result, BDCs like Prospect, Ares Capital (ARCC -0.20%), and Apollo Investment (AINV -0.47%) all have impressive payout yields, but investors have to be careful to realize that those distributions represent nearly all of a company's available net income. Below, we'll take a closer look at Prospect Capital and how it's positioned for the future.

Dividend Stats on Prospect Capital

Source: Yahoo! Finance.

Will Prospect Capital's dividend keep climbing?
Prospect Capital has put together a fairly strong record of consistent dividends over the years. Between 2004 and 2010, the business development company boosted its payout in 22 consecutive quarters, more than quadrupling along the way. But when Prospect shifted to monthly payouts in 2010, it also happened to reduce its dividend payments by about 25%. Still, Prospect's dividend history has been more stable than Ares or Apollo, which have both seen payments fluctuate in both directions over the past several years.

Prospect has sustained such a high yield in part by being willing to scour the universe of available investments for the best opportunities. As Prospect COO Grier Eliasek discussed in a Fool interview earlier this year, the BDC seeks profits from lending money to private companies, finding promising buyouts, providing aircraft leasing deals, and investing in real estate, as well as structured strategies like collateralized loan obligations and syndicated debt investing. By keeping default rates down and picking equity investments with the best return potential, Prospect Capital has produced the income that keeps its dividends high.

But Prospect Capital's business carries plenty of risk. In its most recent quarter, the BDC fell well short of expectations and failed to produce enough income to cover its dividend obligations. Lower origination volume cut into one major source of income, while the bankruptcy of one of the companies in Prospect's portfolio and deteriorating conditions for other key portfolio companies could lead to trouble ahead. Like Ares, Apollo, and other BDCs, Prospect has seen its typical yields on its investments fall dramatically, now earnings three percentage points less than it did last year.

Source: Tax Credits, Flickr.

Pressure on Prospect's dividend?
Because Prospect has fallen just short of covering its dividend payments with income, it has had to issue new shares in order to grow and generate greater amounts of fee income. But as conditions in the credit markets keep tightening lenders' ability to generate outsized returns, Prospect will find it increasingly difficult to have enough cash come in to finance its distributions.

Yet Prospect intends to counter this trend in part by moving into higher-yielding investments. The challenge will be to avoid taking on greater default risk as a result of the move, but Prospect has done a reasonably good job in the past of controlling that risk. Moreover, moves that could generate more fee income as well would be an even bigger net positive for the BDC.

For now, one of the most enticing things about Prospect Capital is that its stock trades at a discount to its most recently reported net asset value. In some cases, that sort of behavior can be a harbinger of future bad news, and many believe that Prospect's dividend is in serious danger. Conservative investors might prefer to wait for the inevitable share-price plunge after any dividend cut happens, as even if Prospect reduces its payouts, the stock is still likely to have an attractive dividend yield.