Dividend stocks can be an excellent source of passive income for investors, but not all dividend-paying companies are created equal.
Owl Rock Capital Corp. (OBDC -0.13%) is a dividend stock that yields investors a dividend of 10.2%. High-yield dividend stocks like this can be appealing because of their lofty returns, but they can come with certain risks. Here's why Owl Rock pays such a high dividend, and what you need to know before deciding if it's the right stock for you.
Business development corporations can deliver high dividend yields
Owl Rock is a business development corporation (BDC) that lends to middle-market companies in the U.S. A BDC is simply a company that makes loans or buys equity in private businesses that other bank lenders may find too risky.
BDCs receive legal treatment similar to real estate investment trusts (REITs) in that they both must pay out 90% of their income in the form of dividends. For this reason, BDCs can deliver investors high dividend yields, but those yields come with a risk.
Consider these risks before investing in Owl Rock Capital
BDCs come with risk because of the nature of their investments and their use of leverage in making them. Owl Rock Capital makes loans to middle-market companies, defined as companies with earnings before interest, taxes, depreciation, and amortization (EBITDA) of $10 million to $250 million and annual revenue of $50 million and $2.5 billion. It says that big banks and other lenders overlook companies of this size because stringent regulatory requirements make investing in big, established companies more worthwhile.
Middle-market corporate debt isn't as liquid as that of bigger companies, so if Owl Rock Capital needed to sell that debt in a crunch, it could be difficult to find willing buyers. Owl Rock Capital also uses leverage on its investments to juice returns. Through Sept. 30, its net leverage was 1.18 times debt to equity -- which is just above the BDC industry average ratio of 1.13. This could lead to quick losses in the event of a default or series of defaults on those loans.
To mitigate its risk, Owl Rock does a few things. For one, it spreads its debt investments across 180 portfolio companies at a fair value of $12.8 billion. Of this amount, 72% is in first-lien secured debt, meaning Owl Rock would have first claims on a company's assets if it were to go bankrupt. This type of debt is less risky than subordinated debt, but could still be a problem if a bankrupt company doesn't have enough assets to cover its first-lien debt.
This debt is spread across industries, too, and its largest investments are in the internet software and services industry, which makes up 12.7% of its total portfolio. Financial services and insurance are its next-largest investments, at 9.8% and 8.7% of its portfolio.
A good ultra-high-yield dividend stock for investors willing to take the risk
Owl Rock relies on debt to finance its business and continue growing, and in the past year, lending standards have tightened as interest rates have surged. Half of its debt is floating-rate, meaning the interest rate increases as the federal funds rate rises, increasing Owl Rock's cost of capital. On a positive note, 98% of its debt investments have floating interest rates, so a rise in rates will benefit it more in income than it will have to pay out on its own debt.
The real risk is if companies can't pay their debts and default rates spike. If this were to happen, it doesn't matter how much of its debt is floating-rate if it isn't repaid. While this risk hasn't come to pass, some economists are concerned about a recession in the next 24 months, which could strain those middle-market companies Owl Rock lends to.
If you have a low risk tolerance, you're better off looking for dividend-paying companies with stable income and strong capital management. However, if you don't mind the risk, Owl Rock and its 10.2% dividend yield could make a solid addition to your diversified portfolio.