Updated on May 27th, 2021 by Bob Ciura
At first glance, PennantPark Floating Rate Capital (PFLT) has great appeal for income investors. That’s because PennantPark has a staggering 9% dividend yield.
PennantPark is one of over 100 stocks in our coverage universe with a 5%+ dividend yield. You can see the entire list of 5%+ yielding stocks by clicking here.
Not only that, but PennantPark also 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 currently fewer than 60 monthly dividend stocks. You can download our full Excel spreadsheet of all monthly dividend stocks (along with metrics that matter like dividend yield and payout ratio) by clicking on the link below:
But, as is so often the case with sky-high dividend yields, PennantPark’s attractive dividend yield may be too good to be true.
This article will discuss the company’s business model, and whether or not the payout is sustainable over the long-term.
PennantPark is a Business Development Company, or BDC. It provides mostly debt financing, typically first lien secured debt, senior notes, second lien debt, mezzanine loans, or private high-yield debt. It specializes in making debt investments to middle market companies. To a lesser extent, it also makes preferred and common equity investments.
The company’s portfolio is highly diversified, with no particular industry making up more than 8% of the total mix, and the vast majority comprising less than 3% of the total.
Source: Investor Presentation
In addition, the company’s portfolio is entirely floating rate, which opens up its yields to interest rate volatility. This can be good in times of rising rates, but is unfavorable should rates decline.
An overview of the company’s investment philosophy reveals PennantPark prefers middle market companies with $15 million to $50 million in annual EBITDA, and has a high rate of underwriting success.
Only 13 of the company’s 391 investments since inception have reached the non-accrual stage. This track record of outstanding underwriting is a key advantage for PennantPark.
Source: Investor Presentation
Above is a sampling of the types of investments the company makes in target companies. Not only are the targets themselves from diverse industries and geographies, but PennantPark has a variety of instruments with which to make its investments.
First lien secured debt is the preferred instrument given its favorable repayment position, but the company will do revolvers and equity injections as well. As of the end of March, 86% of PennantPark’s portfolio was first lien senior secured debt.
PennantPark has demonstrated a track record of successful investments. However, its exposure to floating rate instruments has caused its average yield to fall over the past several years. The yield on PennantPark’s portfolio peaked at just over 9% at the end of 2018, but lower rates on risk-free instruments has caused its average yield to decline.
As PennantPark’s portfolio is entirely comprised of floating rate instruments – mostly tied to LIBOR – it benefits when interest rates are increasing. Low rates over the past decade have suppressed the company’s investment income, but the potential for higher rates is a future catalyst.
PennantPark reported first-quarter earnings on May 5th, 2021. Adjusted net asset value per share came in at $12.60, up 2.3% sequentially, while total investment income for the quarter decreased to $19.4 million from $26.3 million in the year–ago quarter. The yield on debt investments was 7.6%.
Meanwhile, the company invested $160.2 million during the quarter in four new and 17 existing portfolio companies with a weighted average yield on debt investments of 7.4%. That said, the company’s sales and repayments of investments for the same period totaled $172.1 million.
Cash equivalents as March 31, 2021, stood at $66.6 million compared to $57.5 million in September 30. 2020. FQ1 net investment income fell to $0.26 from $0.52 in the year–ago period.
While we believe PennantPark has the track record and financial means to continue growing in the coming years, we have concerns over its ability to maintain its dividend.
PennantPark pays a monthly distribution of $0.095 per share. The stock has a very attractive annualized dividend yield of 9%. Even better, it makes monthly dividend payments, so investors receive their dividends more frequently than they would on a quarterly schedule.
However, it is also important to assess whether the dividend is sustainable. Abnormally high dividend yields could be an indication that the dividend is in danger.
PennantPark Floating Rate also has a highly leveraged balance sheet and a payout ratio that often nears or exceeds 100% of earnings. While the company can probably sustain this model while the economy is running smoothly –as the growing and stable dividend over the past decade has shown –it may collapse if the economy experiences a significant and prolonged downturn that would cause its loans to underperform.
Still, shareholders should certainly not expect a distribution increase in the near-term given how close the payout is to earnings today. PennantPark’s ability to grow the portfolio and its average yields, while keeping expenses under control, will determine if the distribution is sustainable.
The company currently earns more in NII than it pays out in distributions. Thus, we aren’t expecting a dividend cut, but add that if credit quality deteriorates, or if rates move down further, PennantPark’s earnings will suffer and a dividend cut may become a reality. We note this hasn’t happened yet, but risks have risen for PennantPark given the way its portfolio is constructed with floating-rate instruments.
The old saying “high-risk, high-reward” seems to apply to PennantPark. It certainly has an attractive dividend yield on paper, but there is more risk to the payout than meets the eye.
If everything goes according to plan, the stock could generate nearly double-digit total returns on an annual basis from the yield alone. Higher interest rates would be a positive catalyst, but rates are likely to remain low for the foreseeable future.
There is an elevated level of risk for the company. If PennantPark does not grow investment income, it could be forced to reduce the dividend at some point in the future.
As a result, investors should tread carefully. Only investors with a higher risk tolerance should consider buying PennantPark despite the very high yield.