Don’t Get Blown Up in This High-Yield Income Minefield

The business model captivates: Borrow at a low rate, lend at a higher rate. Then take whatever income is earned on the spread and distribute it to shareholders. By doing so, you pay dividends that generate 10%, 13% and even 15% yields. That’s business development companies (BDCs) in a nutshell.
Of course, it’s a bit more complicated than that. BDCs borrow by raising debt in capital markets. The proceeds are either lent or invested in middle-market companies (companies with revenue between $20 million and $200 million). If you master the business, the money flows. The spread between borrowing and lending can be as high as 8%, double the spread of the better-run banks.
From an investor’s perspective, yield is the attraction. What’s more, yield is found without digging too deeply.

Higher-Yield BDC Sampling

I’ll confess to cherry-picking the above table, but not specifically for yield. These five BDCs are relatively long in the tooth compared to their peers. Their histories as publicly traded entities predate 2008. All five have endured at least one recession. Most BDCs trading today are of newer vintage.  Most began trading post-2009. No one knows if they possess staying power.
All five of these BDCs survived the last recession, but hardly with flying colors. If you had bought all five on their initial public offering dates, you’d be sitting on a capital loss today. Worse, if you’d bought all five of them two to three years after their IPO date, you’d be sitting on a deep capital loss.
The enticing yields are the product of lower share prices. The lower share prices, in turn, are the product of dividend cuts. Except for PennantPark, payouts have been reduced across the board (and PennantPark is priced as if a reduction looms). In the BDC sphere, as the dividend goes, so goes the share price.
Income investors frequently fall victim to the BDC siren song – high yield.  Unfortunately, BDC management can act as the siren. Here, I’ll single-out Prospect Capital for antipathy. Its president and COO, Grier Eliasek, has been particularly effusive on Prospect’s high yield (see here and here). Eliasek has been somewhat less effusive on the history behind the yield.
Permit me to expound on Prospect’s dividend and yield history.
Prospect’s dividend was initially paid quarterly. From 2005 through early 2010, the dividend was marginally increased. In 2009, Prospect shares closed the year at $12. The $1.62 dividend paid in 2009 produced a 13.5% yield on that closing price.
So far, so good … until.
In 2010, management thought it better to pay dividends monthly. After all, many income investors rely on investment income to meet monthly expenses. It appears Prospect management was adopting a more shareholder-friendly stance. That is, until you factor in the math. Prospect’s monthly payout was set at $0.10 a share. Instead of receiving $1.62 a year, investors would receive $1.20 – a 26% reduction – going forward.
Prospect subsequently raised its dividend a fraction of a cent each quarter. The monthly dividend had inched up to $0.1106 a share by January 2015.
But then history repeated itself. Prospect cut the monthly dividend 27% to $0.08 a share with the March payout. Prospect shares now trade around $7.50, compared to $12-$16 when the dividend was paid quarterly. But guess what? The current yield is 13.4%, and that’s the selling point.
Many BDCs have similarly abused their long-term investors. Nevertheless, many new income investors fail to consider the history behind that high BDC current yield. To be sure, past isn’t always prologue, but as Prospect proves, many times it is.
I dislike most BDCs, but I still like the business model. When mastered, the model generates reliable high-yield income. A few select BDCs have mastered the model.
One of the select few is a current High Yield Wealth recommendation. This BDC has been a recommendation since early 2011. It yields 9.2%. Just as important, it has never reduced its payout during our recommendation period. To the contrary, it has raised its dividend three times in the past four years. Better yet, this BDC frequently supplements its quarterly dividend with special dividends.  The latest supplement occurred with the March payout.
To learn more about this High Yield Wealth best-of-class BDC – and other time-tested income-producing strategies – click here. Dependable high-yield BDCs are difficult to find, but not impossible.