Fifth Street Finance Corp (NASDAQ:FSC) is a business development company, or BDC, with a diverse portfolio of investments, a high dividend which it pays monthly, and is very adaptable to a rising interest rate environment.
Despite this, weakness in the BDC sector has produced an opportunity to buy Fifth Street Finance at a historically low valuation. Here is a closer look at the reasons Fifth Street Finance is a bargain at the current price and has a lot of potential for big gains in your portfolio.
1.) A diverse portfolio
Although the individual companies Fifth Street Finance holds debt in are not of the best credit quality, there is strength in the diverse portfolio.
Fifth Street holds the debt of about 125 different companies in industries such as construction, logistics, health care, airlines, industrials, foodservice, and technology. Some of these companies are actually very well-known, such as Edmentum education services and ReBath, a construction company that specializes in bathtubs.
What this means to shareholders is that even if any one of these companies went out of business, or otherwise defaulted on its debt, it wouldn't affect the income or capitalization of Fifth Street all that much.
2.) High income, paid monthly
With a current dividend yield of around 10.7%, Fifth Street is among the most attractive income stocks paid in the market. So, how can the company afford to pay so well?
Because the company finances other businesses whose credit quality is so-so, the debt holdings in the portfolio pay very well. In fact, Fifth Street's average return on its debt holdings is 10.8%. The company loans its own money, plus borrows additional money to then loan to other business at a profit.
To further sweeten the deal, Fifth Street's dividends are paid monthly, not quarterly. So, for those of you who are retired or rely on your investments for income, you'll get paid more frequently.
For investors who want to build wealth, your investments compound faster than with quarterly dividend stocks. A 10.7% dividend when paid monthly actually works out to an effective annual yield of about 11.3% when you take the frequent compounding into consideration.
3.) Could make more money if interest rates rise
Not only is Fifth Street ready to survive the rising interest rates most experts predict will occur in the next few years, but Fifth Street's income could actually rise considerably.
If you look at the list of investments in Fifth Street's latest annual report, you'll see the individual debt holdings listed as something like "First Term Lien Loan, LIBOR + 6%". Most are LIBOR plus a percentage between 5% and 10%.
Meanwhile, Fifth Street's borrowing is either at much lower floating rates (mostly LIBOR + 2.25%) or at fixed rates of between 3.35% and 5.375%. So, the spreads will either remain the same in the case of the floating rate debt, or will widen in the case of the fixed-rate debt.
In other words, as the LIBOR rates (the rates banks lend each other money for) increase, Fifth Street will get paid more on most of its investments. In fact, 74% of Fifth Street's investments have variable interest rates.
4.) Sector weakness
There is considerable weakness right now in the BDC sector. In March, the S&P Dow Jones and Russell indices announced they would remove BDCs due to accounting and reporting requirements. The reconstitution of the indices is expected to be completed by the end of June, so the selling of BDC stocks by index funds is creating a lot of downward pressure.
Fifth Street can actually be bought for less than the value of its assets right now, having fallen by about 4% since the March announcement of index restructuring. Once the selling pressure is over, the stock might not be on sale for much longer.
To sum it up, Fifth Street is an inexpensive and diverse way to create a fantastic income stream in your portfolio. Also, as interest rates rise, we could actually see some upside and dividend increases due to the nature of the debt portfolio. Fifth Street Finance deserves to be considered for any portfolio with the goals of building wealth or creating income.
Matthew Frankel has no position in any stocks mentioned. 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.