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Business Development Companies, commonly known as BDCs, offer exceptionally high dividend yields and thus they are popular in the community of income-oriented investors. BDCs are close-end investment firms that make debt or equity investments in small or mid-size companies. These companies cannot borrow funds from banks or via the issuance of bonds and hence they resort to BDCs. In exchange, BDCs try to receive attractive returns from these companies.

As BDCs are obliged by law to distribute at least 90% of their investment income to their shareholders in the form of dividends, they offer exceptionally high dividend yields.  The other reason behind the high yields of BDCs is the increased risk of these stocks, as their investments to small-size companies that are not eligible for loans from banks certainly belong to the high-risk category. In this article, we will discuss the prospects of three high-yield BDCs.

Prospect Capital Corporation (PSEC)

Prospect Capital Corporation provides private debt and private equity to middle-market companies in the U.S. The company focuses on direct lending to owner-operated companies as well as sponsor-backed transactions. Prospect invests primarily in first and second lien senior loans and mezzanine debt, with occasional equity investments.

BDCs face cut-throat competition from their peers and hence they do not enjoy any sort of competitive advantage. Prospect is not an exception. It is also important to note that Prospect has hardly extended its balance sheet over the last decade. As a result, it does not enjoy the advantages that result from a great scale.

Moreover, Prospect has grown its net investment income during the last decade but has failed to grow its net investment income per share due to the hefty issuance of new shares. Since 2012, its share count has nearly quadrupled and thus its net investment income per share has decreased 55%, from $1.67 in 2012 to $0.75 in 2021. As a result, the stock has dramatically underperformed the S&P 500 during the last decade (-29% vs. + 207%).

Due to its poor performance record, Prospect has reduced its dividend, from $1.22 in 2012 to $0.72 now. It is also important to note that the stock has paid the same dividend for five consecutive years. Given also the current payout ratio of 92%, it is evident that the 9.3% dividend of the stock has a thin margin of safety.

On the other hand, as BDCs are obliged to distribute at least 90% of their net investment income in dividends, their dividends almost always have a thin margin of safety. Notably Prospect has been able to maintain payout ratios above 100% for years. Moreover, the stock is trading at only 73% of its net asset value (NAV) and thus it is offering an attractive combination of yield and valuation. Of course, investors should always be aware of the high vulnerability of BDCs to recessions, as the investments of BDCs are severely hurt by recessions.

Stellus Capital Management (SCM)

Stellus Capital Management is a BDC that bills itself as a flexible source of capital for the middle market. The company provides capital solutions to companies with EBITDA of $5-$50 million and does so with a variety of instruments, mostly with debt securities.

Just like Prospect, Stellus has exhibited a lackluster performance record, but the decline of its net investment income per share has been less dramatic. Since 2013, Stellus has incurred a 16% decrease in its bottom line, from $1.33 to $1.12.

On the bright side, Stellus has proved remarkably resilient to the coronavirus crisis. Its net investment income per share has slipped only 9%, from $1.23 in 2019 to $1.13 in 2020 and $1.12 in 2021. On the other hand, the resilient performance resulted primarily from the short duration of the recession in 2020, as the government offered unprecedented fiscal stimulus packages in response to the pandemic. If Stellus faces a prolonged recession in the future, it will probably incur a steeper decrease in its net investment income.

Stellus is currently offering an 8.1% dividend yield, with a payout ratio of 95%. In the absence of a recession, the company is likely to maintain its dividend, particularly given its positive business momentum. In the fourth quarter, Stellus grew its adjusted net investment income 13% over the prior year’s quarter, primarily thanks to higher interest income from its investments. Overall, its 8.1% dividend appears to be safe in the absence of a recession. On the other hand, as the 8.1% yield is a nearly 10-year low level for this stock, investors may want to wait for a more attractive entry point.

Sixth Street Specialty Lending (TSLX)

Sixth Street Specialty Lending is a specialty finance company focused on providing flexible, fully committed financing solutions to middle-market companies principally located in the U.S. The fund provides primarily first-lien senior secured loans, mezzanine debt, non-control structured equity and common equity. Management aims to co-invest with other firms to maximize the potential for organic growth, acquisitions, market or product expansion, restructuring initiatives, recapitalization, and refinancing.

The portfolio of Sixth Street includes 70 investments, with no company making up more than 3.4% of total assets. The company aims to achieve adequate industry diversification, with business services, consumer products, and education accounting for 16.8%, 12.3% and 12.2% of its exposure, respectively, amongst 14 other industries.

Sixth Street has exhibited a volatile but superior performance record when compared to the above two BDCs. Since it became public, in 2014, Sixth Street has grown its net investment income per share at a 2.3% average annual rate.

On the other hand, while other BDCs are recovering strongly from the coronavirus crisis, Sixth Street is facing some headwinds. In the fourth quarter, its net investment income per share decreased 25% over the prior year’s quarter while its net asset value per share dipped 10%. The disappointing performance was caused primarily by increased interest expense, which in turn resulted from higher outstanding debt.

Moreover, the stock is currently offering a nearly 7-year low dividend yield of 7.5% and is trading at a price-to-NAV ratio of 1.3. Therefore, despite the healthy (for a BDC) payout ratio of 82%, investors should probably wait for a better combination of yield and valuation.

Final Thoughts

Many income-oriented investors are attracted by the above-average dividend yields of BDCs. Indeed, these stocks usually offer attractive total returns under favorable economic conditions. However, investors should be aware of the high vulnerability of BDCs to recessions due to their investments in small-cap companies that cannot borrow funds from traditional channels. Therefore, even if some investors decide to invest in BDCs, they should keep their allocation to this category of stocks at a low level.