Big Yield Means Big Risks
Globally speaking, interest rates are at their lowest level in human history, which explains the immense interest in higher-yielding dividend stocks like BDCs. But you always need to remember that Wall Street isn’t a charity, and no one is going to offer you such mouthwatering income returns without a whole lot of risk in most cases.
In the case of BDCs, the cash flow supporting the dividend mainly consists of high interest loans to companies that other banks won’t touch. In other words, these are higher risk, subprime borrowers who have no better alternative for financing their businesses.
Now, that doesn’t mean that all BDC loans are created equal. Just like with bonds, there are different types of loans, of varying quality, with higher risk generally corresponding with higher interest rates.
This brings me to the major risks associated with this industry and why it’s vital to be very selective when investing in this industry.
For example, higher cost BDCs (usually the externally managed ones, like Prospect Capital) have to reach for yield in order to be able to cover their dividends. This means lending to riskier, often distressed companies, including in out of favor industries such as those in the oil & gas sector.
In addition, some of these loans are riskier than others because unlike the highest quality bonds, they are unsecured, meaning no collateral backing them up. So in the event that the company defaults on its loan the BDC can end up taking a big loss, which shows up as a decline in NAV/share, the equivalent to the book value per share of a bank.
Since share price generally tracks NAV/share over time, a decline in NAV caused by defaults and loan write-offs means a lower share price and a harder time for the company to raise equity capital at high enough prices (i.e. a low enough cost of equity) to grow NAV/share over time.
Or to put it another way, BDCs, because their investment capital comes so much from equity markets, are at the mercy of fickle investor sentiment. If share prices fall too low because management made too many speculative loans that are now defaulting (and forcing dividend cuts), the share price can fall low enough to trap the BDC in a downward spiral of declining NAV, ongoing dividend cuts, and an endless downward spiral in share price that results in permanent destruction of investor capital.
Part of the problem which brings up another important risk is that like most specialty finances industries, there are very low barriers to entry. Basically, in today’s world, which is awash in almost free money, anyone can set up a BDC and compete for customers.
Which means that, as interest rates have stayed low for so long, net interest margins, or the difference between the cost of borrowing and the interest rate at which BDCs can make loans, has steadily declined.
This has only made the higher cost BDCs more desperate and forced to go out further on the yield/risk curve, making steadily riskier loans. Of course, when economic conditions,or specific industries get hit hard, such as with oil companies in this era of low energy prices, this can result in higher default rates, which is what Prospect management recently admitted to on a conference call.
As this chart of Prospect Capital’s dividend shows, the BDC industry, like banking, is cyclical, tracking economic health. Since we are now eight years into the post Great Recession recovery, the economic/credit cycle may be about to turn, meaning that a recession is more likely. No one can forecast macro conditions with any real consistency, but recessions are not good for BDCs.
Prospect Capital Dividend History, Source: Simply Safe Dividends
Unfortunately, since many BDCs went public after the financial crisis, thanks to zero interest rates making their high-yields more attractive, investors seeking a track record that spans various economic and interest rate conditions don’t have many options, other than Main Street Capital, Ares Capital Corp, and Triangle Capital, all of which are at least a decade old, with battle tested management teams that survived the great recession.
Note that Triangle Capital is both internally managed and generally considered one of the best managed BDCs in the industry. Yet even it has had to cut its dividend in recent quarters thanks to relatively high exposure to loan losses in the oil & gas industry.
As for Main Street and Ares Capital, you’ll notice two things about their payout histories. First, they occasionally issue special dividends. This is because of the need for occasional “catch up” dividends. That happens when profits are so high that the regular dividend would result in the company going under the 90% regulatory income distribution. Since a loss of BDC status would result in heavy tax penalties, a catch up dividend is used to prevent this painful and shareholder value destroying event.
But more importantly, even good BDCs can have variable payouts over time. This is a result of how the business model is structured for tax reasons. In other words, like mortgage REITs, BDCs are higher risk, higher-yield financial stocks, and with that comes higher volatility.
This ultimately means that dividend investors need to use prudent risk management (i.e. only owning a few select BDCs and only as part of a well-diversified dividend portfolio). That’s assuming you want to own them at all.
After all, if you are a retiree living off dividends and your primary goal is a secure, always rising income stream, then neither BDCs nor mREITs really meet your needs. Sure, they can be a small part of a larger portfolio, but their risks are very real.
Of course, assuming your risk profile, time horizons, and goals allow for BDCs, how is an investor to determine what is a good one, such as Main Street Capital, and which are potentially “value traps” like Prospect Capital?
