Dividend reinvestment plans (DRIPs) allow investors to turn regular dividends into new shares upon receiving the payout. Over time, the compounding effect results in more shares, and more income when the DRIP is turned back off.
Some dividend stocks are more suitable for DRIPs than others, though. And in one industry -- business development companies -- they're par for the course.
In fact, most BDCs have an opt-out DRIP, which requires that shareholders formally choose to receive cash rather than shares. Should you use it?
Virtually every business development company pays a dividend yield in excess of 8% per year. Many yield more than 10%. And nearly all of them offer an easy and convenient dividend reinvestment program to turn those luscious dividends into new shares.
But whether you should use the DRIP varies by BDC.
One of the most lucrative dividend reinvestment programs comes from Fifth Street Finance (NASDAQ:FSC). The company offers a 5% discount on stock purchased through the program, so long as shares are issued at prices above net asset value, or NAV. Thus, if shares trade on the open market at an 8% premium, shares purchased via the DRIP would be purchased at roughly a 3% premium. Over time, that can really add up.
Most other dividend reinvestment plans aren't so lucrative. Apollo Investment (NASDAQ:AINV) and Ares Capital (NASDAQ:ARCC) happily offer a dividend reinvestment plan, but do not subsidize it with potential discounts when shares trade above net asset value. Most BDCs fit in this category.
What about valuation?
The one major problem with a DRIP is that it buys indiscriminately, even if shares trade at a massive premium to book value.
In any given year, an externally managed BDC will trade at or below NAV. It seems to happen with regularity, regardless of what is happening in the broader markets. Thus, with a DRIP turned on, it's probable you'll overpay for shares at a premium when a discount to NAV might be just around the corner.
In general, and ignoring the impact of commissions paid to your broker, it's probably best not to DRIP your BDC dividend yields. Rather, let the dividends pile up and invest when you can get a price at or below NAV. Almost every single externally managed BDC will give you the opportunity to buy shares at a discount a few times a year, more than making up for missed dividends along the way.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Apollo Investment.. 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.