Published by Bob Ciura on June 13th, 2017
Now that the Federal Reserve has begun raising interest rates, yields are starting to climb. However, rates still remain well below their pre-Great Recession levels.
As a result, high yields are hard to find.
Gladstone Capital Corporation (GLAD) is a BDC with a current dividend yield of 8.4%.
It is one of 416 stocks with a 5%+ dividend yield.
And, including GLAD, there are only 29 stocks that pay dividends each month, versus the more traditional quarterly or semi-annual payment schedules.
GLAD’s dividend yield towers above the rest of the market. The S&P 500 Index, on average, has a dividend yield of just 2%.
This article will discuss why GLAD could be an attractive stock for income investors.
GLAD is a closed-end management investment company. It operates as a Business Development Company, and invests in debt and equity securities.
As of December 31st, 2016, GLAD had total investments of $288 million at fair value.
The companies it invests in typically have several features in common:
- Stable earnings and cash flow
- Strong management teams
- Lower-middle market focus
These are companies with leadership positions in their respective industries, growth potential, and annual EBITDA between $3 million-$15 million.
A selection of GLAD’s portfolio investments is as follows:
Source: Quarterly Performance Review, page 16
In order for GLAD to keep paying its hefty dividends to shareholders, it is critical that its investment portfolio continues to generate interest and dividend income and capital gains, in excess of its operating and financial expenses.
GLAD’s debt investments primarily consist of senior term loans, senior subordinated loans, and junior subordinated loans, made to small and medium sized businesses.
It has a diversified portfolio, both in terms of deal sourcing, and industry groups.
Source: Quarterly Performance Review, page 15
Loans made to these businesses are usually between $7 million-$30 million, with terms of up to seven years. Equity investments include preferred or common stock.
GLAD seeks to maintain a 90%-10% split between debt investments and equity investments.
Thanks to GLAD’s investment strategy, the company has considerable growth opportunities to look forward to up ahead.
GLAD is generating strong growth rates, thanks to its investment strategy. Fiscal 2016 was a strong year for the company.
Net investment income rose 10% for the year, to $1.79 million.
One of the most compelling growth catalysts for GLAD in 2018 and beyond, is rising interest rates.
GLAD stands to benefit from higher interest rates, because the vast majority of its debt portfolio is in variable-rate securities.
Source: Quarterly Performance Review, page 14
Approximately 89% of GLAD’s portfolio is tied to floating rate investments. This means rising interest rates will boost GLAD’s investment income.
According to the company, GLAD’s net interest income will increase by 7% each year, if interest rates (as measured by LIBOR) rise 100 basis points.
Should interest rates rise by 300 basis points, GLAD’s net interest income stands to rise by 25% each year.
This would allow the company’s strong results to continue. GLAD is off to a good start in 2017.
Last quarter, GLAD reported net investment income of $5.36 million, up 9% from the same quarter last year.
Investment income declined 7% year over year, but this was more than offset by reductions in operating expenses and advisor fees.
Net asset value rose 5.2% year over year, to $8.33 per share. Portfolio investment activity continues to accelerate, which should help grow net asset value over the long-term.
GLAD invested $39.0 million in two new portfolio companies last quarter, and another $600,000 in existing portfolio companies. In the same period, it received $14.6 million in repayments.
In addition, strong investment performance drives GLAD’s rising asset values. For example, GLAD ended the most recent quarter with $313.5 million in total assets, an increase of 6.8% from the same quarter last year.
GLAD pays a monthly dividend. It recently declared a dividend of $0.07 per share for April, May, and June.
On an annual basis, GLAD pays a dividend of $0.84 per share. Based on its current share price, this equates to a dividend yield of 8.6%.
GLAD has made over 160 consecutive monthly cash distributions on its common stock. Before moving to a monthly dividend schedule, it had paid eight consecutive quarterly common stock cash distributions.
Therefore, GLAD has a solid track record of steady payouts, even during the Great Recession. The company can maintain its high yield, thanks largely to its tax classification.
BDCs are required to distribute at least 90% of any taxable income. This eliminates income tax at the corporate level, allowing capital gains to be passed through to shareholders, similar to a REIT.
Importantly, the current dividend payout appears to be sure. Last quarter, GLAD’s net investment income of $0.21 per share fully covered its dividend.
This is a tight payout ratio, which means the company cannot sustain a major industry downturn and maintain its dividend.
GLAD has mitigated this risk by investing in high-quality companies. More than half—approximately 54%–of GLAD’s loans consist of secured, first-lien loans.
Last quarter, only 2.4% of debt investments were considered non-performing. GLAD ended the quarter with a modest long-term debt to equity ratio of 55%.
As a result, were another significant financial crisis to occur, GLAD’s dividend could be in jeopardy. That said, assuming continued economic growth, plus the tailwind of higher interest rates, GLAD’s dividend appears to be sustainable.
Investors should approach sky-high dividend yields with caution. High yields are commonplace in the BDC asset class, but many have cut their dividends over the past few years.
While dividends are never guaranteed, GLAD management was emphatic on its last quarterly conference call that the dividend is secure and sustainable.
Investors will need to pay close attention to GLAD’s future earnings report. It has a tight payout ratio, and any significant deterioration in the performance of GLAD’s investment portfolio could threaten the dividend.
That said, if investment performance remains strong, and interest rates keep rising, GLAD’s 8.4% dividend yield could be attractive for income investors.