Business Development Companies (BDCs) offer dividend investors an attractive option because they combine generous yields with relatively low leverage. BDCs are in the group of companies which are required to pay out 90% of earnings as dividends; they do not have to pay corporate income tax but the dividends are generally taxed as ordinary income to the shareholders. This makes BDCs very attractive for tax deferred accounts such as IRAs.
For investors starting to invest in this sector, I advise that consideration be given to some of the most solid and stable BDCs. This group includes BDCs that have the size necessary to support administrative costs. Another key factor is asset mix; solid BDCs should have a high proportion of their assets in senior debt instruments. I also look for at least some track record to get a sense of how they perform during a downturn. Finally, it is very important that leverage not get out of hand and so I look for companies whose leverage is well below the limit. Three very solid BDCs are Ares Capital (NASDAQ:ARCC), Prospect Capital (NASDAQ:PSEC) and Fifth Street Finance (NYSE:FSC). After each symbol, I will include Monday's closing price and the current dividend yield.
1. ARCC (16.22) (8.9%) - ARCC acquired the old Allied Capital and, thus, has the longest track record. It invests in a very high percentage of secured debt (about 71% of the total portfolio). In recent quarters, there seems to be a strong commitment to invest in conservative debt instruments. ARCC has some debt but it is well below the one to one ratio which is applicable to BDCs. This is a very solid BDC with a scale necessary to support administrative costs.
2. FSC (10.26) (13.2%) - FSC entered the market relatively recently and so FSC doesn't really have a track record demonstrating how it performs in a market panic. On the flip side, it does not have a high proportion of its assets in investments made during the euphoria which prevailed prior to the panic. FSC is now definitely large enough to be cost efficient. It pays the highest dividend of the group of three. As with ARCC, FSC has a high percentage of its assets in senior secured debt. It is also well below the leverage limit and should be able to weather storms without having to liquidate assets at fire sale prices in order to resolve leverage problems caused by asset write downs.
3. PSEC (10.64) (11.4%) - PSEC acquired the old Patriot Capital in 2009 and is large enough to achieve returns to scale. It has a very large percent of its assets in senior secured debt (equity investments are only some 11% of the portfolio). While it has some debt, it is not close to having a leverage problem. While it has somewhat of a concentration in the energy sector, it is also active in other markets.
While my strategy has generally been to buy BDCs well below book value and, in this market, this usually involves investing in companies that are having problems. I also own all of the above names. For an investor starting out in the sector or for an investor who is gun shy on the "troubled" BDC front, these names offer generous yield and reasonable stability.