When investing for passive income, the allure of high-yield dividend stocks is undeniable. Dividend stocks can be an excellent addition to any portfolio because of their income and potential capital appreciation.
High-yield dividend stocks promise big payouts and can appeal to income investors looking for income streams. Like any investment, high-yield stocks come with their share of risks that investors should know about.
One high-yielding dividend stock is FS KKR Capital Group (FSK 0.58%), which has a yield of 14.7%. Read on to see why FS KKR Capital's dividend is so high, as well as whether it's a good investment to add to your portfolio.
Image source: Getty Images.
What makes FS KKR Capital's dividend so high?
FS KKR Capital is a business development company (BDC) and regulated investment company for U.S. federal income tax purposes. The most important takeaway from this is that the company must distribute 90% of its net investment income to shareholders in the form of interest, dividends, or capital gains. This tax structure is a primary reason BDCs offer high dividend payouts for their shareholders.
FS KKR Capital primarily invests in debt in private, middle-market companies in the U.S. These companies have annual earnings before interest, taxes, depreciation, and amortization (EBITDA) of $25 million to $100 million. It primarily serves middle-market companies because it believes that traditional financial institutions neglect these companies in favor of larger, more established businesses.
Even though middle-market companies represent a significant portion of the growth in the U.S. economy, a limited number of investors are willing to extend loans to them, partly because of the risk of holding these loans. These companies require more oversight, active participation, and monitoring by lenders to evaluate risks on an ongoing basis -- and FS KKR Capital believes it has the platform to do this.
The risks of lending to middle-market companies
FS KKR Capital aims to take a prudent approach to its investments. It looks to invest in companies with strong competitive positions within their industries that are profitable and generate good cash flow. It also looks to invest in management teams with a track record of success.
While it takes a systematic approach to its investments, it's not without risk. Lending to private middle-market companies comes with the risk of not having as much information as with publicly traded companies.
If companies cannot repay their debts, there is the risk of loan defaults. If the economy were to slow significantly, many middle-market companies could feel the pressure, and some may be forced out of business if cash flows don't adequately cover their loan repayments.
FS KKR looks to mitigate these risks in a few different ways. For one, 69% of its investments are in senior secured first-lien or second-lien loans. This means that if one of its borrowers cannot repay its debts, it would have priority over other creditors when it comes to getting repaid on its loans. In addition, 61% of these loans are first-lien, meaning the company would have priority over all others when being repaid.
It also spreads its risks among various industries. The top industry investments are in software and services (16.5%), capital goods (15.4%), healthcare equipment and services (12.8%), and commercial and professional services (11.6%).
An excellent dividend stock, if you don't mind the risk
FS KKR Capital is an appealing dividend stock because of its high yield. Another attractive feature of the company is that 70% of its debt investments are in variable interest rate loans, meaning when interest rates rise, its interest income increases with them. The average yield on its debt is 11.4%, up from 8.7% at the end of 2021. As a result, its interest income in the first quarter grew 25% from the same period last year.
Most of its loans are performing in line with expectations, too. At the end of the quarter, 6% of its loans are underperforming, meaning there is some concern about a loss of interest or dividend payments, or a risk of not recovering its principal investment.
A weakening economy could pose a risk to the business and result in an uptick in underperforming loans. If you're OK with these risks, FS KKR Capital could be an excellent high-yielding dividend stock to add to your diversified portfolio.
