Like dividends? Even if generating investment income isn’t your current priority there’s a case to be made for growth investors owning certain dividend-paying stocks. And if income is your thing right now, you’ll absolutely want to take a look at a handful of business development companies, or BDCs. Many good ones have been beaten down of late due to rising interest rates and, more recently, worries about economic weakness. Both headwinds are seemingly starting to fade.
Here are three top BDC names to consider stepping into while they’re still down.
Business development companies explained
But, first things first: What the heck is a BDC?
Small companies need capital to grow. Business development companies provide it. This money is usually supplied in the form of a loan, although it’s not terribly unusual for a BDC to also receive equity in a budding company in exchange for cash.
This funding tends to be higher-risk to the lender — it’s likely the borrower can’t even get a conventional loan. That’s why business development companies often charge very high interest rates on this borrowed money. Unlike conventional bank loans or bond issuance, though, in exchange for their capital BDCs are often highly involved in the day-to-day management of the borrower’s business. That’s the “development” aspect of this sliver of the capital markets industry.
The appeal to investors is clear — BDCs offer above-average dividend yields supported by the above-average interest payments they receive from borrowers.
The chief risk is also clear. That’s the above-average chance one or more of a business development company’s borrowers will be unable to continue making payments on their loan. This of course threatens a BDC’s ability to continue paying its healthy dividend. A weak economy only aggravates this risk.
Then there’s the other factor that can impact the price of a business development company’s shares (which trade just like ordinary stocks, by the way). That’s interest rates, or more specifically, changes to interest rates. Since their relatively high dividend payments are the chief reason to own a BDC, these tickers are highly sensitive to interest rate ebbs and flows. The string of interest rate hikes the Federal Reserve has dished out since the middle of last year unsurprisingly worked against most business development companies’ share prices.
Except, the global economy is seemingly sidestepping a recession at the same time rate hikes are likely nearing their end, setting the stage for BDCs to bounce back. As Fitch Ratings noted of business development companies in August following the release of their second-quarter results, “Credit metrics remained stable overall, with some modest restructuring activity that led to realized losses, but overall no broad indications of portfolio deterioration.”
To this end, three BDC names stand out among the rest.
Best of the best BDCs
The first of the market’s bigger business development company names to consider is Ares Capital (ARCC 1.21%).
As of September Ares owned nearly $23 billion worth of assets, the vast majority of which are first- and second-lien secured loans to its 490 different borrowers. Software companies and healthcare companies are the most represented industries in its portfolio but with the exception of software (at 23%), no single industry accounts for more than about 10% of its loan portfolio.
Interestingly, while many other lenders are hinting that their capital structures and cash flows are weakening under the weight of lending woes, Ares Capital’s is improving. See, the majority of Ares’ loans are floating-rate loans. The recent uptick in interest rates is ultimately costing its borrowers more. A year ago the average yield on its loans stood at 10.7%. Now it’s 12.4%. Yet, these payments are still largely being made just as they were then. At the same time, Ares’ debt-to-equity ratio of 1.07 as of the end of September is down from 1.27 a year ago, having fallen for four straight quarters. This signals at least a little added flexibility for Ares at a time when it’s needed.
Obviously, there’s no ironclad guarantee these metrics won’t worsen in the foreseeable future. If it hasn’t happened yet, however, jumping in while Ares Capital shares are yielding 10.1% is a palatable risk/reward ratio.
While Ares’ yield is high, it’s not as high as the one being offered by Prospect Capital (PSEC -0.78%). Its yield currently stands at an incredible 14.2%.
The reason for this sky-high yield is Prospect shares’ drubbing since mid-2021. The stock’s down 44% from the multiyear high made then, reaching yet another multiyear low just this week even though the monthly (yes, monthly) dividend payment of $0.06 per share is still being made like clockwork.
What gives?
It’s likely got a lot to do with the company’s underlying revenue and subsequent earnings. Revenue has come up short of estimates more than once since then, and income has been shrinking. Although not yet a threat to its dividend, the bottom line’s recent action is concerning.
PSEC Net Income (Quarterly) data by YCharts
Then there’s the fact that the size of Prospect’s dividend payment hasn’t budged in years. For all intents and purposes, it may as well be a bond; its stock is certainly acting like one. However, it has a ridiculously big yield that’s still being paid. It’s worth renting for a while even if not worth owning for the long haul.
Last but not least, take a look at Main Street Capital (MAIN 3.07%) before we get too deep into the month of November.
It’s arguably the least risky of the three BDC names in focus here. That’s why its current dividend yield of 7.4% is also the lowest of the three business development companies in question. In this vein, Main Street Capital shares are also down the least of late.
Credit the company’s approach to funding small companies and its discipline, mostly, for this lack of volatility. Whereas other BDCs are often just one of a handful of lenders to their client companies — each with their own agenda — Main Street Capital aims to be a one-stop shop that can offer a combination of term loans, lines of credit, and mezzanine debt. It also doesn’t do deals bigger than $250 million and is even then picky about who it partners with. While this may limit the number of deals it does, it ultimately keeps Main Street Capital out of the sort of trouble that sneaks up on other business development companies and their shareholders.
And the resulting quality of its loan and equity portfolio is readily evident in its dividend growth even if not in its current yield.
ARCC Dividend data by YCharts
Sure, its dividend runs into the predictable headwinds when economic turbulence surfaces. That’s why it’s not a great first-and-only holding for an investor needing dividend income to pay bills.
Main Street’s long-term dividend growth speaks volumes about the resiliency of its borrowers, however. That’s why it’s a solid income-producing pick for investors who want to build up cash reserves for other uses or simply tamp down their portfolio’s overall risk.
