Reap 8% of dividends from growing small businesses

Since traditional banks abandoned business lending over the years, BDCs (business development companies) have stepped in.

As an asset class, BDCs earn 8%. We’ll discuss three popular payers – with dividends of up to 8.3% – in a moment.

Congress created the BDCs in a few pencil strokes in 1980, creating an incentive structure to provide financing to small businesses. BDCs enjoy special tax privileges and, in return, they must remit at least 90% of their taxable profits to shareholders in the form of dividends.

If this sounds familiar to you, it’s because the same compromise is enjoyed by real estate investment trusts (REITs), which were formed in the same way, 20 years ago.

As with REITs, the requirement that BDCs must distribute 90% of their income as dividends leads to oversized returns. An average yield of 8% is huge:

That’s a yield of 8%… On AVERAGE

Just be sure to explore this industry with your eyes wide open.

The BDC space is notoriously difficult, both to operate and to invest. Business development companies must compete with other sources of funding; they tend to invest in smaller companies, which are exceptionally sensitive to economic conditions; and they are difficult to assess given the minimal information on the companies in their portfolio. (Track recordings are important in this space.)

But if you want to try some truly life-changing returns with the potential for growth, these PE-esque stocks are hard to match.

Today, I am going to present three BDCs that show potential.

PennantPark Variable Rate Capital (PFLT)

Dividend yield: 8.9%

In February, I explored a few high yield stocks that could actually suffer a jolt from rising interest rates.

Remember: BDCs are lenders. To varying degrees, they can negotiate loans with a “floating rate” component – and the higher the interest rates, the higher the BDC’s earnings.

Enter PennantPark Variable Rate Capital (PFLT).

PennantPark’s current portfolio includes around 100 mid-market companies, spanning 42 different industries. These businesses include glass distributor American Insulated Glass, marketing department Phoenix Marketing International, and veterinary hospital service provider Pathway Partners.

As the name suggests, PFLT makes these investments almost entirely through senior secured variable rate loans.

This exposure seemed like a blessing at the start of the year, when interest rates looked set to take off amid an unbridled economic recovery. But they didn’t. In fact, rates have gone from 1.7% in March to 1.3% today, and PFLT is performing on par with the industry.

On the one hand, PFLT still offers a high dividend – paid monthly, no less – and is among the best-positioned BDCs when interest rates finally bounce back down.

The other side of the coin? The security of dividends remains a question mark. I mentioned that in February analysts at Janney Montgomery Scott predicted that PFLT would not earn enough net interest income (NII) to cover the dividend in 2021 and 2022. Well, more recently, Oppenheimer confirmed, claiming that NII would be below the core. $ 1.14 in dividends that PennantPark is expected to pay.

Capital of the main street

MAIN
(MAIN)

Dividend yield: 6.1%

Main Street Capital (MAIN) is what BDC’s industry comes closest to being reliable blue-chip stock.

This $ 2.8 billion business development company provides debt and equity financing solutions to lower middle market companies, and debt financing (primarily senior secured debt at variable rates) to companies of the middle market.

Its typical target company generates annual revenues of between $ 10 million and $ 150 million, and EBITDA of around $ 3 million to $ 20 million. The portfolio currently has 177 investments, the largest of which represents only 3.2% of total investment income. Meanwhile, no industry accounts for more than 7% of the portfolio in terms of cost, and MAIN is even geographically diversified, with as much as 15% invested in any of the five regions of the United States.

Net Distributable Investment Income (DNII) has improved every year since 2007, and its long-term performance largely reflects that story.

This pattern is a bit more erratic per share – while the DNII increased between 2018 and 2020, the DNII per share from $ 2.76 in 2018 actually fell to $ 2.66 in 2019 and then to $ 2.26. in 2020. But things are clearly normalizing in the short term. . The DNII for the last 12 months is 11% higher than the total for 2020 and 6.6% per share.

In fact, things are going so well that Main Street has even started increasing its regular dividend again, from 2.4% to 21 cents per month. It may not seem like much, but it’s better than most of the rest of the industry has done in the past couple of years. Not to mention, Main Street has a habit of issuing special dividends on excess profits – it stopped during the pandemic to keep its regular payment intact, but a return to normal could mean a possible return to that extra money.

The biggest problem is no surprise. Investors tend to flock to the best traders, and this is clearly the case with MAIN stocks, which trade at 1.8 times the company’s net asset value, one of the highest premiums of all. of the sector.

Potential capital (PSEC)

Dividend yield: 9.3%

Potential capital (PSEC) is another massive BDC with $ 6.2 billion invested in 124 portfolio companies. It primarily operates through senior senior and senior loans and mezzanine debt, although it will also invest in products such as secured loan bonds (CLOs), market loans and multi-family real estate. .

Like Main Street, Prospect Capital spreads its investments across a wide range of industries, from energy and healthcare to financial services and food. But it should be noted that there is a fairly significant concentration risk, namely that 20% of the portfolio is invested in National Property REIT, which makes it even more difficult to assess PSEC given that the REIT is essentially its own portfolio of 58 properties. .

With a market capitalization of $ 3 billion, Prospect Capital is one of the few BDCs larger than Main Street. But it’s rarely seen as being in the same category… at least, not by income investors. That’s because PSEC has a pockmarked dividend history that saw BDC cut its monthly payout in 2015 and 2018. This has largely limited long-term stocks.

It also means that investors should closely monitor PSEC’s ability to meet its obligations. And for now, it looks like BDC has little room for error. Most estimates for 2021 and 2022 have Prospect Capital’s NII just one or two cents above or below its projected 72 cents per share in annual dividends.

Brett Owens is Chief Investment Strategist for Contrary perspectives. For more great income ideas, get your free copy of his latest special report: Your early retirement portfolio: 7% dividends every month forever.

Disclosure: none

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