Most (though not all) BDCs are sucker yields

There are few things more seductive to income investors than a double-digit dividend yield.

Dangle a 10% or higher yield in front of our eyes, and our pupils turn into dollar signs. That’s the only thing we see, forgetting all of our high-minded talking points about slow and steady income.

Really, we can be just as bad as the hard-core growth crowd when a “sucker yield” comes our way.

That’s what I call unusually high dividend opportunities that look oh-so-tempting on the surface while really masking significant risk. They tend to generate mediocre or outright horrible total returns in the end.

And right now, I think that unfortunate description fits almost all business development companies, or BDCs.

Before anyone gets too upset over that assessment, let me explain that I don’t think BDCs are inherently bad entities. I’m happy the classification exists to provide capital to companies that can’t get it from traditional banking sources – predominantly small and middle-market organizations.

The resulting contracts tend to be riskier, so they come with higher interest rates. And that, in turn, can make BDCs profit-generating machines.

Here’s another thing investors often like about them: They naturally come with higher-than-average dividends.

Like real estate investment trusts (REITs), they must pay at least 90% of their otherwise taxable annual income to shareholders. Yet because they run in financial realms, the resulting yields tend to be more significantly sized. That’s to be expected.

What shouldn’t be expected is how so many of those yields are well into the double-digit realm – with some even exceeding 20%!

That right there should tell you something is wrong.

Go ahead and look at such BDCs all you want. But enter at your own risk.

Here’s one way to look at the BDC problem I’m referring to…

Let’s say you loan me $10 and, in return, I give you $1 every year until you want your money back.

Sounds like a decent deal. Right?

But now let’s say that, five years in, you find out your initial investment has dropped in value to $6. All of a sudden, those $1 distributions don’t seem so attractive.

That's essentially what’s going on with most BDCs right now. But investors aren’t necessarily catching the clues, blinded by the appeal of high dividend yields.

So let me make the bigger picture clear: Dividends aren't magic.

They have to come from somewhere.

Strong businesses fund those payouts through their earnings and cash flow – but only after they’ve reinvested capital at attractive rates of return and increased their enterprise values. It’s not that dividends are an afterthought for them; it’s that management knows they can’t be sustainably funded unless everything else is properly addressed.

Many BDCs don’t fit into that “strong business” definition from the get-go. They too often rely very heavily on leverage in order to make loans to companies that carry their own significant debts.

It only stands to reason then that some of those borrowings won’t work out in the end.

That’s why I always look at net asset value (NAV) per share when analyzing BDCs. Years and years worth of NAV, in fact. Because there is a definite chance that it will show a starting point around $15 per share… but a drop to $10 within the decade.

I recently went back about that far for a number of well-known BDCs to compare NAV numbers. And here’s what I found:

Unfortunately, those findings didn’t surprise me all that much. Not when some of them are sporting the yields they are.

Now, Main Street Capital (MAIN) up at the top of the scoreboard is perhaps the best example of a BDC run right. Its NAV per share has risen roughly 54% since 2016 – and all without jeopardizing its dividend.

Again, this is the reason why I can’t condemn all BDCs. There are definitely good ones out there.

Main Street is doing precisely what income investors should want it to do. It’s growing its business in healthy ways that end up positively impacting the economic value of what shareholders put into it.

Unfortunately for outsiders, that level of quality is showing in its current stock price. The market recognizes the solid job Main Street is doing, so it’s not trading at a discount. As such, I can’t recommend it at this time.

We want cheaper entry points than that.

Then again, just because an asset – BDC or otherwise – isn’t trading at a premium doesn’t make it a bargain. Sometimes stocks are cheap because they’re misunderstood, yes. But more often, they’re cheap because there’s something wrong with them.

This brings me to Prospect Capital (PSEC), near the bottom of the previous chart. Its NAV has fallen from around $9.62 per share in 2016 to around $5.71… about a 41% decline.

So, yeah. It’s trading at a discount for a reason.

Prospect is also offering an 18% yield – one of the largest dividend yields you’ll find among “respectable” stocks – for a reason. And that reason isn’t good either.

The economic value beneath those top-line numbers keeps shrinking. And I don’t know how much more it can fall before something has to give.

Like the dividend.

Prospect’s current payout system is unsustainable at this point. All it will take is one more negative event to crumble the company’s ability to pay its shareholders.

These same issues apply to other BDCs in (and outside of) our sample. For instance:

As for evaluating FS KKR Capital (FSK) and Oaktree Specialty Lending (OCSL)? Well, they’re a bit more complicated thanks to recent corporate actions such as mergers, predecessor entities, and reverse splits.

But bottom line: I still wouldn’t touch them at this time.

I want to see clean numbers before I invest in any set of operations. And I want to see clean numbers that will stay that way even if the companies in question come under economic pressure – sector-specific or beyond.

The same has to go for their clients, naturally, since it’s their clients who are ultimately funding everything. While everything can look wonderful on a BDC’s balance sheet during good times – with portfolio companies making their payments and interest income pouring in – that can change far too quickly.

Loans might suddenly need to be restructured… Portfolio companies begin to struggle… Equity investments start getting marked down…

All of which weighs on NAV. And just like that, it can become very clear why the yield was so high to begin with.

This is why the SEC specifically warns about BDCs’ dependence on leverage. While those borrowings can magnify their gains, it’s going to do the same exact thing with their losses.

And this is on top of how much more difficult it can be to truly evaluate BDCs when the very nature of what they do messes with their ability (or at least obligation) to be transparent.

Whenever I see a high-yielding BDC, I bypass the standard question of, “How much can I make from it?” Instead, I jump right to wondering:

And finally: What has its total return been?

The dividend yield doesn’t factor in at all until I’m satisfied in all those other areas. Because, ultimately, a sustainable payout is much, much more important than a high one.

Think otherwise, and you run the very real risk of becoming a sucker.

Happy SWAN investing,

Brad Thomas
Editor, The Wide Moat Daily