There's something high-yield BDC investors need to hear: Your dividends aren't sacred.
Perhaps you're new to BDCs. You might have found their impressive 8-12% yields appetizing in a low rate environment. Maybe you liked the idea management has to pay out 90% of income as a dividend.
Whatever the reason, you like BDCs like Fifth Street Finance (NASDAQ:FSC) or Prospect Capital (NASDAQ:PSEC). That's more than OK. As someone who writes about these interesting high-yielders, I'm glad you've found them.
But if there's one thing I want you to remember, it's BDCs are, for the most part, nothing more than a bond fund. They invest primarily in debt owed by nonpublic companies -- companies (you've heard this before) too small for Wall Street.
BDCs are not a business on their own. They're not a cola company, or a detergent company. They're funds that hold investments.
Most dividend stocks today give investors false impressions. Executive teams work hard to manage their dividend, making sure dividends go up, year after year, even if earnings do not. In fact, dividends often move up, regardless of a company's net income.
It hasn't always been this way. My colleague, Morgan Housel, wrote an excellent piece on how dividends have changed. You should read it.
Drawing a connection
In 2010, Vanguard's Total Bond Market ETF (NYSEMKT:BND) paid out dividends that were consistently over $0.20 per share, per month. In January 2010, it paid out more than $0.25 per share. The last dividend, paid this month, was only $0.17 per share. Since 2010, dividends have dropped by one-third.
No one was shocked. No one was outraged. Bond yields have come down, and legacy debt from pre-recession borrowing sprees has been refinanced at lower rates. Naturally, Vanguard's bond fund throws off a lower yield.
In that time, several BDCs have cut their dividends. Fifth Street Finance cut its dividend to $1 per share per year, paid in monthly installments of $0.0833 per share, down from $0.958 per share the year before. Investors sent shares down more than 10% in the days that followed an obvious need to slash its monthly dividend payments.
THL Credit (NASDAQ:TCRD) recently announced it underearned its $0.34 quarterly dividend rate in the fourth quarter, earning only $0.27 per share in net investment income. The company's share price fell immediately, dropping more than 11% since the announcement.
In both cases, falling yields have hurt Fifth Street's and THL Credit's ability to pay double-digit yields. It's not a reflection on the business. It's not if they are cola companies that simply sold less soda. Rather, each dollar THL Credit and Fifth Street Finance deploy today earns a lower yield than before. It's the same reason Vanguard's bond fund pays a lower dividend in 2014 than it did in 2010.
This is an industry-wide trend, though you won't notice if you look only at stock yields. Prospect Capital has announced continuously increasing dividends all the way out to September 2014. This is despite the fact its portfolio yielded 12.9% as of December 31, 2014, a full one percentage point less than in March 2013, when it yielded 13.9%. Prospect Capital is paying more, even as it earns less on each dollar invested. (For what it's worth, Prospect Capital isn't currently earning enough to pay its dividend from quarterly income.)
The point I want to make is this: BDCs are not your traditional business. Falling income isn't the result of a poor advertising campaign, or an inability to keep its products on the shelves. Sometimes, falling income is just a result of the business environment. And when the business environment changes, dividends have to change, too.
Jordan Wathen 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.