Do you want high yields, but don't want to take on the risk of investing in higher-risk business development companies? You may have a better option. Here are two BDC investment opportunities that offer an attractive middle ground with above-average yields.
Make this a mainstay
BDC investors love Main Street Capital (MAIN 1.10%) for its impressive track record. Not only did the company pay dividends throughout the financial crisis, but it also increased its dividends in every year except 2010. Few business development companies can match that claim.
Investors are seemingly so eager to invest in the company that shares now trade at 1.5 times book value. In essence, investors pay $1.50 for every $1 in its investment portfolio -- most BDCs are lucky to trade at just a 10% premium to book value.
A high price-to-book ratio puts pressure on implied yields. If you buy today, you'll theoretically earn a yield of just 6.4%, little more than half that of rival BDCs.
Main Street Capital's portfolio quality and history are certainly above par for the BDC universe. The BDC has a highly diversified portfolio of investments in 164 different companies, and only 0.7% of its investment portfolios is performing under expectations. But if a 6% dividend yield is all you want, there may be a better way to play the company.
A 6% yielding middle ground
Main Street recently raised $92 million by selling notes to the public under the name Main Street Capital. The notes yield 6.125%, paid quarterly, and at the current price of less than $24 per note, they yield 6.4% per year -- the same as the stock. The notes will be redeemed at $25 per share in April 2023.
The notes may be a better risk-adjusted investment than the stock. Remember, notes have a claim to the balance sheet before shareholders, which means Main Street must pay distributions to note-holders before it doles out more to its equity investors.
While an earnings miss could send Main Street's common stock dividend and share price plummeting, earnings would have to fall by more than 100% to affect payments to note-holders, making the high-yield notes a better alternative for risk-adverse investors.
A yield prospector's choice
Like Main Street, Prospect Capital (PSEC 1.39%) ranks high on the list of quality BDCs, thanks largely to its balance-sheet makeup. The company invests mostly in higher-quality senior debt of middle-market companies.
Prospect's common stock trades at a price roughly equal to book value, giving it a yield of 12%. Since the financial crisis, Prospect has regularly increased its monthly dividend while reporting solid performance for its underlying portfolio. The company hasn't had a single non-performing loan in nearly six years.
It's tough to judge a business development company in the current market climate. The last six years have been extraordinarily favorable to high-risk lending, amid lending liquidity and a recovering economy. But what if you wanted a less risky investment than Prospect itself?
The 7% alternative
Playing it safer with Prospect Capital is as easy as buying its senior notes, which trade as Prospect Capital Corporation (NYSE: PRY).
The notes won't be redeemed until 2022, and they yield 6.95% at the current price of $25 per note.
The 6.95% notes also have preference to earnings before shareholders, so poor performance from the underlying portfolio won't immediately affect the interest payments to noteholders.
Safety does come at a price: The notes yield 5 percentage points less than the equity. But that trade-off may be more than fair for investors who are focused first on the safety of their investment capital. Prospect Capital's earnings would have to turn negative, and book value would have to take substantial writedowns before note-holders felt the pinch.
The Foolish bottom line
Investors shouldn't limit themselves to only stock or only debt. Investments are only as good as their alternatives.
If you're unhappy with the low dividend yields available in blue-chip stocks, but too risk-averse to invest in BDCs, BDC notes offer an interesting midpoint between risk and reward that may be suitable for your income portfolio.
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