Updated on March 7th, 2019 by Josh Arnold
In the stock market, reaching for high yields often backfires. To be sure, stocks with extremely high dividend yields look great on the surface. However, stocks with high yields are often the ones with the greatest level of risk in their distribution.
For example, Capitala Finance Corp. (CPTA) has a staggering 13% dividend yield. Capitala is one of 390 stocks with a 5%+ dividend yield.
Not only that, but Capitala (like many Business Development Companies, or BDCs) pays its dividend each month. This allows investors to compound their wealth even more quickly than a stock that pays a quarterly or semi-annual dividend.
There are fewer than 40 companies that pay monthly dividends. We’ve compiled a list of monthly dividend stocks that you can access below:
At first, such a high dividend yield looks like a no-brainer. Who wouldn’t want to earn a 13% return just from dividends?
But looking closer, there are potential pitfalls when it comes to these extreme high-yielding stocks.
This article will discuss why Capitala’s dividend yield—while certainly very enticing—is better left for only the most risk-tolerant investors.
Capitala is a Business Development Company, or BDC. The company has $2.7 billion in assets under management and it uses that capital to provide lower and middle market businesses with debt or equity financing.
The company’s strategy focuses on investing in debt securities and minority equity co-investments, typically for companies with enterprise values lower than $250 million. Additional criteria used in evaluating investment opportunities include annual revenue of $10 to $200 million, and TTM EBITDA of $4.5 to $30 million.
The company has invested in over 150 different companies since its inception in 1998 and seeks to partner with strong management teams to create value and achieve optimal outcomes for shareholders.
The investment portfolio is highly diversified, across many industry groups and asset classes. About half of the total investment portfolio is comprised of first-lien debt, as of the end of 2018.
Source: Investor Presentation
Approximately 79% of the portfolio consists of debt investments, with the remaining 21% in equity investments.
The company reported its full-year 2018 results on March 4th, 2019. During 2018, the company originated $108 million of new investments and received $123 million of repayments. New investments were nearly exclusively in debt, with only $1.8 million in equity investments.
Total investment income was $47.3 million for the year, which was down from $51.1 million in the same period in 2017. Interest and fee income was flat compared to 2017, while payment-in-kind income decreased by $2.8 million, and dividend income decreased a further $0.8 million.
Payment-in-kind income as a percentage of total income fell from 14% to 9.2% year-over-year, which was an improvement that was an area of focus in 2018.
Total expenses fell $4.3 million for the year thanks to a decrease in financing expenses and a sizable decline in losses related to debt extinguishment, among other factors.
Net investment income for the year was $16 million, or $1.00 per share, which was up fractionally from 2017. Net assets at the end of 2018 were $190.6 million, or $11.88 per share, which was well down from 2017’s ending value of $13.91 per share.
The company continues to pay its monthly distribution of $0.083, totaling an annualized distribution of $1.00. Capitala has never paid a return-of-capital distribution; all payouts come from investment income.
Capitala has two key catalysts for future investment income growth. The first is to invest more money, which will generate higher income.
The company regularly puts new money to work and in 2018, it invested $93.5 million, 84% of which was first lien debt.
Source: Investor Presentation
This is consistent with Capitala’s push to boost returns and reduce risk by investing in more senior debt, and is helping to boost its overall portfolio’s percentage of first lien debt.
The company also recently formed the Capitala Senior Loan Fund II, which is a joint venture with Trinity Insurance. The partnership’s initial goal is $150 million in size and will invest in first-out senior secured loan positions.
We expect Capitala will continue to raise and invest more capital, primarily in senior loan instruments, for many years to come. This is the primary way in which Capitala will grow in the coming years.
The second catalyst is to earn more on its existing investments, although the company already earns a very high portfolio yield.
The company’s weighted average debt yield is 11.9% as of the end of 2018, which is down from prior values in excess of 13%. Still, this is a very high level of returns in a low-rate environment and Capitala has achieved this with a well-diversified base and with companies that have strong rates of cash flow.
The 100% payout ratio should be a concern for investors going forward. There is no wiggle room for the dividend, which calls into question the sustainability of Capitala’s hefty dividend payout if business conditions continue to deteriorate.
However, Capital has operated this way for years as its distribution is generally at or near 100% of its investment income. With initial estimates for investment income for this year at $1.00 once again, consistent with 2018, the payout ratio will once again be ~100%.
Capitala has a current dividend monthly payout of $0.083 per share. On an annualized basis, the dividend payout is $1.00 per share.
Based on its current stock price, Capitala has a dividend yield of 13.0%. The dividend was covered with net income in 2018, but only barely.
As mentioned, coverage of the dividend has been very tight for years at this point, and it has resulted in several distribution cuts since the IPO. If net investment income declines from current levels, the dividend will be at risk.
Capitala has only $19 million of debt maturities in 2020, and none in 2019. This provides the company a meaningful respite from the cash crunch that would befall it with large debt maturities.
However, the long-term is less certain. Maturities will spike to $187 million in 2021. This will be a challenge, as this represents several years of net investment income.
As a result, Capitala may not be a good stock for investors interested in long-term dividend growth. To be fair, Capitala has a flexible capital structure and has refinanced its way out of large maturities before. Still, it is certainly something for investors to keep an eye on.
Stocks with 10%+ dividend yields look great on paper. But with such high yields often comes high risks. With a 100% dividend payout ratio, Capitala has very little margin for error.
Investors looking for steady, more reliable income would be wise to steer clear of high-yield BDCs. Instead, keep focus on the tried-and-true dividend stocks, such as the Dividend Aristocrats.
You won’t find any Dividend Aristocrats with 10% yields, but in return, the Dividend Aristocrats offer sustainable payouts and long track records of annual dividend increases.
Capitala has a much shorter dividend history, and a very high payout ratio. It may be able to sustain its dividend going forward, but the level of risk may not be appropriate for all investors.