This is a series of articles to find BDCs to include in my updated "High-Yield Portfolio" for Q3 2014 that is for investors that are willing to take on a little more risk with less stock price appreciation, but higher dividend yields. The other four portfolios types are 'Total Return', 'Risk Averse', 'Value' and the 'Underdog' portfolios that will be updated on my "Portfolio Updates" page . The primary concern for high-yield investors is whether or not the dividends are sustainable. This article will discuss dividend coverage using three measurements: the last five quarters core net investment income ("NII") compared to dividends paid during the same period, the results from my "BDC Dividend Coverage" series and projected analyst EPS.
Last 5 Quarters
There are pros and cons to using historical earnings compared to actual dividends paid. The biggest issue is that there is always a certain amount of one-time income and/or expenses. BDCs know this as well and should plan their distributions accordingly so it is still a valid measurement. I have updated this analysis to include core NII that excludes both income and incentive fees related to capital gains as well as some of the major onetime expenses and is a more accurate measurement of recurring income to cover dividends. However I have not spent as much time analyzing BDCs that are less likely to cover dividends in the future such as BlackRock Kelso Capital (NASDAQ:BKCC), KCAP Financial (NASDAQ:KCAP) and Full Circle Capital (NASDAQ:FULL). The table below provides some of the detail for my quarterly core NII.
The following table uses calculated core NII from the previous table compared to the regular dividend paid during the same period to assess historical dividend coverage.
Yield compression has been an ongoing issue in the BDC industry over the last two years and the table above displays reduced dividend coverage over the last four quarters. As you can see the average coverage for higher yield BDCs has declined from 103% to 91%. In my recent article Total Return Part 2: "Historical & Potential Dividend Coverage" the decline was less going from 103% to 95% over the last four quarters implying that some higher yield BDCs may have experienced more yield compression in the portfolio. This is certainly true for Prospect Capital (NASDAQ:PSEC) with the largest decline in its stated yield from 15.10% to 12.76% but part of this was intentional as the company focused on higher amounts of senior debt investments. THL Credit (NASDAQ:TCRD) and FULL have also had larger declines in portfolio yield than the average BDC.
Projected Dividend Coverage
The table below combines the dividend coverage results from the previous table with my "optimal leverage" analysis that uses the current cost structure and capital expenses for each BDC along with the amount of equity as of March 31, 2014 (or most recent), a debt-to-equity ratio of 0.80 and the current portfolio yield to project income and expenses. For more information on this approach to projecting dividend coverage please read "BDC Dividend Coverage Part 1".
I have indicated which BDCs have higher dividend yields most of which rank lower from a dividend coverage standpoint. However Medley Capital (NYSE:MCC) and Apollo Investment (NASDAQ:AINV) seem to have higher amounts of coverage. However this analysis does not take into account lower portfolio yields and I believe TCRD and TICC Capital (NASDAQ:TICC) could both have dividend coverage issues in the following quarters. I have also indicated which BDCs use or have the ability to use SBA debentures that allow the company to borrow more than the average BDC to increase returns for higher coverage in the future including MCC, Fifth Street Finance (NASDAQ:FSC) and PennantPark Investment (NASDAQ:PNNT).
The following table shows the projected analyst EPS for the next two quarters. These amounts are usually similar to my core NII but do not always exclude onetime expenses from capital gains.
I have highlighted KCAP because it has a history of missing EPS estimates with the exception of last quarter and should be watched closely. BKCC has missed estimates by 25% to 60% over the last three quarters. FULL and Horizon Technology Finance (NASDAQ:HRZN) are not projected to cover dividends over the next two quarters.
Using these three measures of dividend of coverage would imply the best BDCs for this portfolio are AINV, MCC, PNNT, PSEC and FSC. The rest of this series will continue to look at historical results and projected performance of higher yield BDCs to uncover the best companies for this portfolio. The key criteria I will be analyzing are:
- Relative valuations
- BDCL as a component
- Risk vs. returns
Investors should only use this information as a starting point for due diligence and please see my frequently updated "Index to BDC Articles" for more information.
Disclosure: The author is long ARCC, FSC, FSIC, GBDC, HTGC, MAIN, NMFC, PFLT, PNNT, PSEC, TCPC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.