Not all high-yield stocks are created equal. Investors looking for yield sometimes forget or are not aware that the same yield does not indicate the same relative safety from stocks in this group.
If the economy continues to grow, the majority of high-yield companies will continue to pay the current dividends. The financial news outlets have been beating the drum of recession indicators. If you are in the camp that thinks an economic slowdown is coming soon, its time to reassess the dividend paying ability of your high yield stocks.
The core fact behind earning big dividend is that the
business behind the shares much generate enough free cash flow to cover the
dividend payments. Analysis of high-yield stocks should focus on how a company
generated cash, what would cause cash flow to fluctuate, and how much excess
coverage of the dividend the company generates.
For recession resistance in a dividend paying stock, you
want to see a business operation that will stay profitable when the economy slows,
and you would like to see free cash flow well in excess of the dividend
Business Development Companies (BDCs) are one type of high-yield
stock that do not meet the criteria for recession safety.
The BDC laws were enacted to allow companies to use a
tax-advantage business type with the goal of providing financing options to
small to mid-sized corporations. This is a portion of the business community
that is too small to access the public debt and equity markets and too risky to
get business loans from commercial banks.
So specifically, BDCs provide debt and or equity capital to
small corporations. Most BDCs focus on making loans, to earn interest.
According to the BDC rules, at least 90% of net investment
income as dividends. Shares of the companies in the sector are typically priced
to carry between high single digit to low double digit yields.
Unfortunately, there is a range of problems and dangers to
investing in BDCs. While there are a few outstanding BDCs, the business
structure and how it is implemented makes investing in this group often dangerous
to investor wealth.
Here are some of the problems with the BDC sector.
- These companies make loans to high-risk
companies. BDC clients overall are more susceptible to an economic downturn.
- BDC rules dont allow these companies to set
aside loan loss reserves. Since the sector is designed to serve a riskier slice
of the business world, loan losses are inevitable and a BDCs book value will
inevitably experience erosions. Management of a BDC must devise business
strategies to offset the ongoing portfolio declines.
- BDC rules limit the amount of leverage a company
in the sector can use. To grow the business and offset portfolio losses, a BDC
will regularly issue new common stock shares to raise capital. For this to
benefit shareholders, the shares should be trading at a premium to book/net
asset value (NAV). A BDC trading at a discount to NAV is not a good deal.
To maintain their tax-advantaged, pass-through status most
BDCs payout close to 100% of net interest income as dividends. This means if
business slows, or client companies cant make loan payments, BDC dividends
will have to be slashed. Here are three stocks from the sector that will be in
trouble if the economy goes to negative growth:
Prospect Capital Corp. (PSEC) is a $2.4 billion
market cap BDC with a 11.3% yield. The stock share net asset value (NAV) has
been in a slow, but steady decline since 2014.
With PSEC trading at a 20% discount to NAV, that decline is
likely to continue, and the company cannot raise capital with new equity
This BDC is popular among the high-yield seeking investing
crowd, but share owners are likely to soon face another dividend cut. Thats
without an economic recession. In a downturn, the dividend could disappear. The
payout was last reduced in 2017. Sell PSEC.
Apollo Investment Corp. (AINV) is a $1.1 billion
market value BDC with a current 11.9% yield. The AINV share price is currently
trading at a 14% discount to NAV.
This companys portfolio is 35% invested in the far riskier
Second Lien debt. Another danger is having 20% of the portfolio invested in
just one company, called Merx Aviation Finance.
As of the 2019 first quarter, AINV had 1.7% of its portfolio
on non-accrual status. Dont let this companys investment grade credit rating
fool you. In a recession, its those inevitable loan losses that result in NAV
erosion, and eventual dividend cuts. Sell AINV
With an $8 billion market cap, Ares Capital (ARCC) is
the largest publicly traded Business Development Company. This is a solid, well
run BDC, not currently at risk.
I put it on the list to show how close even one of the best
companies in the sector is to the financial edge.
From its second quarter earnings, the current ARCC share
price is at a 9.5% premium to book value. In the BDC world, trading at a premium
is a companys safety net, allowing it to grow its way out of trouble. That
discount would quickly disappear in a down stock market.
Second quarter net investment income of $0.49 per share
nicely covers the $0.40 dividend. A year earlier the NII was just $0.38 per
Again, this is a BDC with some cushion against an economic
recession, but a prolonged downturn would not be good for even the largest BDC.
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