Like most investors, I love yield when the market isn't throwing investors any bargains.
One space I think investors should overweight is the business development company industry. These firms make debt and equity investments in small, middle-market companies and pass on most of their earnings in the form of dividends.
Here are my three favorites:
1. The God of War
Ares Capital (ARCC 0.38%) is the biggest business development company on the public markets. Its history as a public company combined with its sheer size (the balance sheet towers over $7 billion) give it two big competitive advantages in recruiting top talent, and in sourcing the cheapest financing.
Because financial companies can rarely, if ever, have an edge, Ares Capital's size and historical performance lead me to believe it's a BDC for the long haul. In rising markets, Ares Capital does just fine. During times of crisis, it's a "too big to fail" BDC that can make opportunistic deals, like its 2009 acquisition of Allied Capital. Being big allows it to be a consolidator, which leaves the door open to big acquisitions when other BDCs are struggling just to maintain their balance sheets.
Ares Capital is very good about covering its dividend with earnings. The bulk of the company's net investment income comes from consistent interest and dividend income, so I believe there is very little threat to the dividend failing a complete fallout in the credit markets. In fact, the company's recent quarter revealed two additional special dividends.
2. The yield prospector
Prospect Capital (PSEC +0.00%) started as a financier of mostly oil and gas wells, but it evolved into a "go-anywhere" BDC that now has major investments in anything from consumer finance to real estate investments.
As the second-largest BDC, Prospect Capital has also shown its strength in poor credit markets, acquiring Patriot Capital in a financial-crisis acquisition that led to impressive returns since the 2008 financial crisis.
Prospect Capital is the highest-yielding BDC on the markets. Its consumer finance business, First Tower, gives it a 20% return annually. Likewise, its CLO investments provide it with returns in the "high-teens."
These investments are riskier than your average BDC investment, but Prospect Capital's historical performance suggests it does thorough due diligence. Investors are fairly compensated with higher risks by its best-in-class dividend yield of nearly 12% per year.
I'd like to see Prospect Capital slow its equity issuance and use more debt to leverage its balance sheet. The company currently operates well under its target leverage ratio of 0.6-0.75. More debt would help earnings meet and exceed its current dividend.
3. Make it on Main Street
Main Street Capital (MAIN 1.09%) is the priciest BDC on the list, but investors are paying up for quality. Main Street Capital operates primarily in the lower middle market. Lower middle-market financing is less competitive, allowing Main Street Capital to secure loans with interest rates topping 14% per year.
Lesser competitive markets also allow for favorable equity investments. The company typically makes equity investments alongside debt deals, giving it two ways to profit. Furthermore, its loans have strict covenants, which require borrowers to repay their loans first. Over time, Main Street Capital is able to write up its equity investments as its portfolio companies pay down debt.
Many of Main Street Capital's monthly dividends are paid out at favorable capital gains tax rates, so its yields are up there with the likes of Ares Capital and Prospect Capital on a tax-adjusted basis. Most BDCs pay out dividends that are taxed as income, not capital gains.
Finally, Main Street Capital insiders own a significant chunk of shares outstanding, which gives shareholders the comfort of knowing that management's interests are aligned with their own.
Make it a great 2014 with these high yielders
All in all, Prospect Capital, Ares Capital, and Main Street Capital offer a compelling opportunity to add a little extra yield to your stock portfolio. Prospect and Ares bring consistent dividends, while Main Street Capital provides big potential for total returns from capital appreciation. Investors who use a buy-and-hold approach and reinvest some or all of their fat dividend yields will likely enjoy very solid total returns over the long haul, not just in 2014.
