Beware These Sky-High Dividend Yields
As global stocks have cratered this year, it follows that dividend yields across the board have climbed. And while in some cases this may present an opportunity for investors, in others it may be a warning sign.
The latter appears to be the situation in regards to one corner of the market, a subsector among lenders called business development companies. These firms, also known as BDCs, make loans to small and midsize companies, typically at higher interest rates than banks. They pay at least 90 percent of their taxable income out as dividends to avoid corporate tax, which also explains their high yields.
As their share prices have tumbled along with the broader market, dividend yields have crept to as high as 20 percent -- levels not seen since markets began to recover from the global financial crisis in mid-2009. In fact, BDCs now offer an average yield higher than all but one company in the S&P 500 Index (pipeline owner Williams Cos. is the exception) and 98 percent of the Russell 3000 Index. Only the worst-rated junk bonds offer more yield, with a side of extra risk.
Wall Street has been increasingly questioning the legitimacy of how BDCs value parts of their portfolio. At the receiving end of a significant level of scrutiny has been Fifth Street Asset Management, a manager of BDCs, which went public in October 2014 at $17 a share but has since withered to $1.43, sending its dividend yield to more than 47 percent. The company and one of its BDCs are now being sued by shareholders for allegedly failing to disclose facts, including concealing the deteriorating credit quality of its portfolio.
That propelled analysts and investors to take a closer look at the sector's largest players, including Prospect Capital Corp. which last week reported quarterly earnings showing the $2.2 billion company values CLOs, or funds that bundle high-yield, high-risk loans, at 93 percent of their cost. That compares to a median valuation of 80 percent by rival BDCs, according to Raymond James analysts, who reminded clients that during the last recession, BDC-like funds were forced to mark their CLO interests to zero.
For its part, Prospect said all of its valuations fall within a range provided by independent valuation firms and described scrutiny by analysts and others as "nothing short of a smear campaign". Since then, the Wall Street Journal has reported that the SEC has begun examining the valuation methodology of such firms, meaning it'll become clear if existing discrepancies are valid.
Until those questions are answered, those juicy dividends might not be worth the reach.
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