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1 High-Yielding Sector Worth a Look

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The more I invest and study the market, the more amazed I become by the variety of investment vehicles available to the typical investor. There are thousands of stocks, bonds, commodities, mutual funds, hedge funds, exchange-traded funds, and finally derivatives that relate to any and all of the preceding instruments and funds.

To make sense of all of these, I categorize them. And my favorite category includes income-paying stocks, as I discussed last week in an article about why smart investors buy dividend stocks. What I want to do now is take this categorization one step further by looking at a specific subset of high-yielding stocks.

Business development companies
If you're an income-seeking investor, you're probably familiar with master limited partnerships like Kinder Morgan Partners and mortgage real estate investments trusts like Annaly Capital Management. To qualify for preferential tax treatment, businesses like these must distribute the lion's share of their earnings to shareholders via dividends -- typically along the lines of 90% thereof. As a result, their dividend yields are generally higher than the broader market; Kinder Morgan's is 5.4% and Annaly Capital's is 13.5%.

In addition to these, there is a lesser-known though related entity known as a business development company. BDCs are closed-end investment firms that invest in privately held middle-market businesses, that is, businesses with revenues between $10 million and $1 billion per year. They are an outgrowth of the Small Business Investment Incentive Act of 1980, and were created by Congress to facilitate the flow of public capital to private companies. BDCs accomplish this primarily through debt financing, and secondarily through the provision of equity.

Because BDCs are entitled to the same type of preferential tax treatment as REITs and MLPs, they too are incentivized to pay out the lion's share of their earnings via dividends. A cursory review of the biggest BDCs demonstrates the impact of this on their yields. Apollo Investment (Nasdaq: AINV  ) yields 14.2%, Prospect Capital (Nasdaq: PSEC  ) yields 11.6%, and Main Street Capital (NYSE: MAIN  ) yields 7.3%.

Some caveats
One side effect of these large dividend payouts is the failure of BDC shares to markedly appreciate in value, as they don't retain earnings. Unlike shares in McDonald's, for example, which pay a dividend and appreciate in value, the only opportunity for return from an investment in a BDC typically comes in the form of the dividends, which also helps to explain why investors demand such a high yield.

Another downfall is their susceptibility to financial stocks. As such, the Great Recession has been tough for many BDCs. For example, American Capital (Nasdaq: ACAS  ) lost 75% of its value, was forced to suspend its dividend, and is now being sued by shareholders for misrepresentation. And things got so bad for the one-time industry leader, Allied Capital, that it was forced to sell itself to competitor Ares Capital (Nasdaq: ARCC  ) at a discount.

As late as last year, in fact, the situation remained somewhat dismal for BDCs, as Fool analyst Anand Chokkavelu discussed in an article about the 10 worst investment companies of 2011. Both Apollo and American Capital made the list, with annual dividend-adjusted returns at the time he wrote the article of negative 33.7% and negative 9%, respectively.

Foolish bottom line
These caveats aside, the right BDC remains a potent vehicle for yield-hungry investors. Not to mention, many of these stocks have performed well since the beginning of the year: Apollo is up 21%, Prospect Capital is up 15%, and Main Street Capital is up 5%.

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Fool contributor John Maxfield does not have a financial stake in any of the securities mentioned in this article. 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.

Read/Post Comments (7) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 03, 2012, at 4:17 PM, jwoods1390 wrote:

    How does ACAS re-purchasing of stock play into the Q4 financial results? Just wondering how that works.

  • Report this Comment On February 03, 2012, at 7:32 PM, gcmagone wrote:

    Looking for a list of BDC stocks that pay monthly. Can anyone help?

  • Report this Comment On February 03, 2012, at 8:14 PM, gdcallies wrote:

    THIS COMMENT IS FOR gcmagone

    prospect capital pays 10 cents per month


  • Report this Comment On February 03, 2012, at 10:54 PM, slburris wrote:

    The monthly BDCs I have:


    Pretty happy with the first two, the jury is still out on FSC.

  • Report this Comment On February 04, 2012, at 4:54 AM, subdriver683 wrote:

    In addition to MAIN, CODI, and SLRC are great in this area. Although CODI has suffered as well this past year.

    I know MAIN is a monthly payer. CODI and SLRC pay quarterly.

  • Report this Comment On February 04, 2012, at 12:30 PM, Chontichajim wrote:

    MAIN Is up 21% since Thanksgiving week and pays its dividend monthly. I have sold some of it back for the profit, but it is also nice to have that dividend every month.

    Like this article says these business investments are the first to go down in any new recession, but otherwise just watch them for management performance and pick the ones that perform when we aren't in a recession.

  • Report this Comment On February 04, 2012, at 1:04 PM, paultaut wrote:

    BDC's Have to pay 90% of their income, it will be interesting to see how PSEC deals with their recent windfall.

    And its unlikely that they will issue new units this year for the same reason.

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