Not all high-yield stocks are created equal. Investors looking for yield sometimes forget or are not aware that the same yield does not indicate the same relative safety from stocks in this group. If the economy continues to grow, the majority of high-yield companies will continue to pay the current dividends. The financial news outlets have been beating the drum of recession indicators. If you are in the camp that thinks an economic slowdown is coming soon, it’s time to reassess the dividend paying ability of your high yield stocks.

The core fact behind earning big dividend is that the business behind the shares much generate enough free cash flow to cover the dividend payments. Analysis of high-yield stocks should focus on how a company generated cash, what would cause cash flow to fluctuate, and how much excess coverage of the dividend the company generates.

For recession resistance in a dividend paying stock, you want to see a business operation that will stay profitable when the economy slows, and you would like to see free cash flow well in excess of the dividend payments.

Business Development Companies (BDCs) are one type of high-yield stock that do not meet the criteria for recession safety.

The BDC laws were enacted to allow companies to use a tax-advantage business type with the goal of providing financing options to small to mid-sized corporations. This is a portion of the business community that is too small to access the public debt and equity markets and too risky to get business loans from commercial banks.

So specifically, BDCs provide debt and or equity capital to small corporations. Most BDCs focus on making loans, to earn interest.

According to the BDC rules, at least 90% of net investment income as dividends. Shares of the companies in the sector are typically priced to carry between high single digit to low double digit yields.

Unfortunately, there is a range of problems and dangers to investing in BDCs. While there are a few outstanding BDCs, the business structure and how it is implemented makes investing in this group often dangerous to investor wealth.

Here are some of the problems with the BDC sector.

  • These companies make loans to high-risk companies. BDC clients overall are more susceptible to an economic downturn.
  • BDC rules don’t allow these companies to set aside loan loss reserves. Since the sector is designed to serve a riskier slice of the business world, loan losses are inevitable and a BDC’s book value will inevitably experience erosions. Management of a BDC must devise business strategies to offset the ongoing portfolio declines.
  • BDC rules limit the amount of leverage a company in the sector can use. To grow the business and offset portfolio losses, a BDC will regularly issue new common stock shares to raise capital. For this to benefit shareholders, the shares should be trading at a premium to book/net asset value (NAV). A BDC trading at a discount to NAV is not a good deal.

To maintain their tax-advantaged, pass-through status most BDC’s payout close to 100% of net interest income as dividends. This means if business slows, or client companies can’t make loan payments, BDC dividends will have to be slashed. Here are three stocks from the sector that will be in trouble if the economy goes to negative growth:

Prospect Capital Corp. (PSEC) is a $2.4 billion market cap BDC with a 11.3% yield. The stock share NAV has been in a slow, but steady decline since 2014.

With PSEC trading at a 20% discount to NAV, that decline is likely to continue, and the company cannot raise capital with new equity issuance.

This BDC is popular among the high-yield seeking investing crowd, but share owners are likely to soon face another dividend cut. That’s without an economic recession. In a downturn, the dividend could disappear. The payout was last reduced in 2017. Sell PSEC.

Apollo Investment Corp. (AINV) is a $1.1 billion market value BDC with a current 11.9% yield. The AINV share price is currently trading at a 14% discount to NAV.

This company’s portfolio is 35% invested in the far riskier Second Lien debt. Another danger is having 20% of the portfolio invested in just one company, called Merx Aviation Finance.

As of the 2019 first quarter, AINV had 1.7% of its portfolio on non-accrual status. Don’t let this company’s investment grade credit rating fool you. In a recession, it’s those inevitable loan losses that result in NAV erosion, and eventual dividend cuts. Sell AINV

With an $8 billion market cap, Ares Capital (ARCC) is the largest publicly traded Business Development Company. This is a solid, well run BDC, not currently at risk.

I put it on the list to show how close even one of the best companies in the sector is to the financial edge.

From its second quarter earnings, the current ARCC share price is at a 9.5% premium to book value. In the BDC world, trading at a premium is a company’s safety net, allowing it to grow its way out of trouble. That discount would quickly disappear in a down stock market.

Second quarter net investment income of 49¢per share nicely covers the 40¢ dividend. A year earlier the net investment income was just 38¢ per share. Again, this is a BDC with some cushion against an economic recession, but a prolonged downturn would not be good for even the largest BDC.

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