In a time long, long ago; in a land far, far away, bankers used to operate on the 3-6-3 principle: Borrow at 3%, lend at 6%, hit the golf links at 3 o’clock.
Today, it’s borrow at 0% from the Federal Reserve and trade leveraged reverse upside-down interpolated backwards credit-default swaps (or some similar contraption) all hours of the day. Then you pray you remain on the right side of the trade long enough to collect a 10-digit bonus before the whole cockamamie scheme blows up.
The traditional approach to banking used to be the secure approach, which is why banks had long been associated with reliable income investments for conservative investors. Modernity has altered the paradigm: Wells Fargo (NYSE: WFC) and JPMorgan Chase (NYSE: JPM) fail to pay dividends that yield 3%. As for Bank of America (NYSE: BAC) and Citigroup (NYSE: C), they yield little more than nothing.
Because banks have moved into the esoteric and the exotic doesn’t mean the traditional banking model of borrowing at one rate and lending at higher rate no longer works. It does, and there are companies posting profits and delivering high-yield income to their investors by doing so.
I refer to business development companies (BDCs). These firms raise money in the debt and equity markets and then use the proceeds to lend to small-to-middle-sized business: Companies that generate $10-to-$200 million in annual revenue.
The 3 Best BDCs for High-Yield Income
Three BDCs, in particular, are bountiful sources of reliable high-yield income for conservative investors.
Take Ares Capital Corp. (NASDAQ: ARCC) for instance. It’s one of the largest and best BDCs available. Its investment portfolio is valued at $7.8 billion and is composed of 195 different companies. These companies provide the essential products and services – energy, financial services, manufacturing, retailing, automotive parts, chemicals, etc. – that keeps the economy humming.
Boring? Yes, but these companies enable Ares to pay income that generates a 9.2% yield. Over the past five years, Ares has increased its payout three times. In addition, it has frequently augmented the payout with special dividends, which further amplify the income stream.
Second to Ares I like Prospect Capital Corp. (NASDAQ: PSEC), which lends and invests in a similar manner. It, too, focuses on middle-tier companies that master the basics: real estate, food services, machinery, etc. Prospect operates on a slightly smaller scale compared to Ares: Its investment portfolio is valued at $6 billion and composed of 138 different companies.
But from an income investor’s perspective, Prospect holds an advantage. It distributes dividends monthly. At the current market price, this income stream generates a 13.5% yield – one of the highest in the sectors.
I’ll be forthright here: Prospect’s share price is depressed on uncertainty associated with how the company presented certain controlled investments in its financial statements. here are issues of contention that Prospect is disputing with the SEC. To be frank, these issues have kept investors away.
With that said, the economics of Prospect’s business remain unchanged. The company has already declared dividends through January 2015. Reporting changes, if any, are unlikely to change Prospect’s ability to generate cash flow.
The third BDCI like operates off the beaten path. Hercules Technology Growth Capital (NASAQ: HTGC) is a niche BDC, focusing on technology: Internet, telecom, biotech, and clean energy. Hercules is also more of a “growth” BDC. The value of its investment portfolio has more than doubled to $890 million in the past 10 years. Management recently stated it expects the portfolio to exceed $1 billion over the next 12 to 18 months.
As the portfolio has gone, so, too, has gone the dividend: Over the past 10 years the dividend has increased to $1.24 a share from $0.33. Today, that dividend yields 8.6%. Given management’s growth target over the next 12 months, dividend growth will likely keep pace with portfolio growth.
So forget the measly yields offered by the big “traditional” banks. Get big, reliable income from lenders like the BDCs that have assumed the mantle of the ancient art of borrowing low to lend high to generate profits and cash flow.
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