Huge Dividends Without the Risk in These 3 Little-Known Companies

Business development companies offer some of the best dividends in the market, but which is right for you?

Apr 1, 2014 at 11:33AM

Business Development Companies, like Prospect Capital (NASDAQ:PSEC) and Apollo Investment Corporation (NASDAQ:AINV), pay some of the highest dividends in the market and do so without as much risk as you might think. The challenge to investors is deciding which of the 32 publicly traded BDCs is the best fit for their particular investment objectives. How much volatility are you willing to endure? How much income do you expect? Do you want a diversified BDC or one that specializes in certain types of financing? Here is an overview of a few of the largest BDCs, what they do, and how well they pay.

What is a BDC?
BDCs are similar to venture capital firms, investing in small to middle market companies. The investments can be in the form of debt or equity in the company, or a combination of the two. Most BDCs are taxed similar to REITs, and therefore must pay out at least 90% of their taxable income to shareholders. Other than these commonalities, BDCs can be very different from one another in terms of what types of companies they invest in and how much risk they are willing to take on.

Very large and diverse
Ares Capital
(NASDAQ:ARCC) is one of the largest BDCs with about $8.1 billion in total assets. The company makes investments that vary widely in size from $1 million to about $400 million and invests in a variety of industries. Ares has an investment portfolio that is diversified among about 200 companies, meaning that if one of them were to default, Ares's income stream wouldn't get hurt all that much.

As far as income goes, Ares pays a dividend of about 8.7% per year. The company was forced to cut its dividend a bit during the financial crisis, but it has done a good job of increasing the payout in recent years. However, this is actually a bit low among BDCs, so let's check out some of the higher-yielding names.

A little more income...
Apollo Investment Corporation is the smallest company on this list, but is still large and diversified enough to provide stable income that should grow over time. The company's portfolio mostly consists of the debt of middle-market companies (about 83% of the portfolio), as well as some smaller positions in equity and structured investment products.  According to Apollo's website, the company has investments in just over 100 companies, including such household names as BJ's Wholesale Club, Del Monte Foods, and Molycorp.

The company pays a 9.7% annual yield and makes quarterly dividend payments, and although the company took a bigger hit than the others during the financial crisis, it has since stabilized and earnings haven't fluctuated by more than two cents per quarter since 2011.

A great yield and high, predictable income
Prospect Capital is slightly smaller than Ares in terms of market cap, and it has a much higher yield. Not only does Prospect pay over 12%, they pay their dividend in monthly installments, which makes compounding dividends more effective and is also very nice for investors (like retirees) who may want a more frequent income stream than quarterly dividends.

Prospect also has a large and diverse investment portfolio that includes the debt of about 130 companies including Totes Isotoner, Targus, Water Pik, just to name a few.

Another reason to love Prospect is that it has already declared all of its monthly distributions through September, and the dividend is scheduled to increase slightly each month. In fact, since the company started paying its dividend monthly (in mid-2010), the payout has increased by more than 10%. Not a tremendous increase, but this should help your income stream keep up with inflation over time.

So, what to do?
Although there are some good choices in the BDC sector, for my money it doesn't get much better than Prospect. The company offers a significantly higher yield, pays its shareholders monthly, and doesn't have much more risk associated with its holdings than the other two.

This is by no means an exhaustive list, but is meant to be an overview of the larger players in the BDC sector. Whichever you choose, invest early and reinvest your dividends, and you'll be surprised at how quickly your money can grow over time.

Is this a better income option than BDCs?
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Matthew Frankel owns shares of Prospect Capital. 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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