If you've been hunting for stocks that pay big dividends, you've probably noticed some business development companies (BDCs) with exciting yields. Before diving in, though, there are a few things you should understand about this niche.
First, BDCs generate most of their revenue financing small- to medium-sized private companies, and avoid corporate income tax by distributing nearly all of their profits to shareholders in the form of dividends. This leads to some big but volatile yields. For example, shares of Prospect Capital Corporation (PSEC +0.00%), and Triangle Capital Corporation (NYSE: TCAP) offer dividend yields above 9% at recent prices.
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Before you jump at these high yields, though, let's look at reasons they could slash their payouts in the near future.
No. 1: Prospect Capital Corporation
Prospect Capital offers a tempting 12.45% yield at recent prices, but the reason it's so high also makes it easy to walk away. At recent prices of around $8.03 per share, the company's market value is 19.8% below its net asset value.
A stock price that far below a BDC's net asset value indicates some serious pessimism concerning its growth story. Fortunately for us, it's easy to see why investors are nervous about Prospect Capital's future. Its exposure to the energy sector led to a sharp uptick in loans considered unlikely to be repaid from $6.9 million at the end of fiscal 2015 to $90.5 million to end fiscal 2016 (Prospect Capital's fiscal year wraps up at the end of June). Chronically depressed oil prices exacerbated an already existing downtrend in the BDC's net asset value, which has fallen steadily from a peak of $10.83 per share at the end of fiscal 2012, to $9.62 at the end of fiscal 2016.
If Prospect Capital were becoming more efficient at drawing profits from its net asset base, it could maintain its dividend despite as it shrinks. Unfortunately, it's moving in the wrong direction. As a percentage of net assets, net investment income sank from from 14.92% in fiscal 2012, to 10.54% during fiscal 2016.
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Prospect Capital didn't generate enough net investment income in fiscal 2014, or fiscal 2015 to cover its dividend, and in early 2015 its shareholders suffered a 24.7% reduction to their monthly payments. If net investment income and operating expenses don't begin moving in the right direction soon, it will probably need to trim the payout even further.
No. 2: Triangle Capital Corporation
At a recent price of around $19.32 per share, Triangle Capital offers a $0.45 quarterly dividend that works out to a juicy 9.32% yield, but a lower payout could be in this BDC's near future. Triangle already slashed its payment 16.67% earlier this year, but the $0.77 it earned in net investment income per share in the first half still isn't enough to cover the lower payout.
Since it reported last, Triangle Capital raised a great deal of equity with a common stock offering that raised its share count by about 6.74 million, or about 20% above the number outstanding at the end of June. The BDC netted proceeds of $129.1 million for the shares, but making dividend payments at the current payout will cost another $12.14 million annually. This will bring annual dividend payments to around $72.67 million. The company finished the first half on pace to record just $51.87 million in net investment income, which suggests an annual shortfall of about $20.8 million, or about $0.52 per share.
Proceeds from the share offering give Triangle Capital more dry powder to make additional investments, but its ability to close the gap between net investment income and dividends paid is questionable. Investors in this BDC recently witnessed a frightening surge in loans it considers unlikely to be repaid across its diverse portfolio, from companies selling shrubbery to mental health services. The cost of these non-performing loans spiked 166% during the six months ended June to $54.3 million, or 5.6% the total cost of its portfolio.
The recent resignation of one of the BDC's founders from his role as chief investment officer and director might help its shrinking asset base reverse course in the years ahead. In the near term, though, it seems another dividend slash is on the way.
Important lessons
Although lower payouts appear to be in the cards for Prospect and Triangle shareholders, that doesn't mean dividend investors should completely avoid the BDC space. If you still want to dip your toes in, it's important to remember they tend to rely on success from dozens of small-ish businesses for their income.
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Smaller businesses are generally more vulnerable to economic downturns and industry-related trends. Since BDCs need to distribute nearly all of their profits, building a cash cushion to smooth out dividend payments during lean years isn't easy.
You might be able to earn a high yield from BDCs in the short term, but given their very nature, expecting years of steady increases just isn't practical. In the long run you're probably better off with top dividend stocks from traditional companies with decades of earnings growth that are well positioned to continue through your retirement years and beyond.
