Updated on May 19th, 2020 by Josh Arnold
At first glance, PennantPark Floating Rate Capital (PFLT) has great appeal for income investors. In fact, after a sharp selloff earlier this year, and with the stock only having recovered some of the lost ground since, PennantPark has a staggering 15.3% dividend yield.
PennantPark is one of over 200 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 line 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.
As of March 31st, PennantPark had a total investment portfolio of $1.179 billion, up from less than $1 billion at the end of 2018, consisting of 108 separate investments in 43 industries.
Source: Investor presentation, page 12
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.
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. With rates hitting historical lows around the world, now is not a good time to be exposed to variable interest rate instruments.
Source: Investor presentation, page 4
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 9 of the company’s 380 investments since inception have reached the non-accrual stage. This track record of outstanding underwriting is a key advantage for PennantPark.
Source: Investor presentation, page 16
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, 91% 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 in recent periods.
Source: Investor presentation, page 8
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 nearly 2%, with no signs the declines are slowing.
The company’s portfolio was well under $500 million at the end of 2015 but today, is more than double that size and is very close to $1.2 billion. PennantPark has been able to grow its portfolio very profitably, keeping a keen eye on credit quality throughout.
As PennantPark’s portfolio is entirely comprised of floating rate instruments – mostly tied to LIBOR – it benefits when interest rates are increasing. With rates very low around the world, and economic uncertainty likely to keep rates low for some time, PennantPark’s only real source of growth moving forward is portfolio growth. It has proven it can do this with strong credit quality in the past, and at some point, higher rates may be a tailwind again. However, that appears to be some time away at this point.
PennantPark’s second quarter results showed core net investment income of $0.30 per share, which is in line with previous quarters. The company’s investment portfolio grew nicely during Q2, with $168 million in purchases, only somewhat offset by $99 million in repayments.
Net asset value per share was $11.10 at the end of March, down from nearly $14 in the year-ago period thanks to mark-to-market losses on its portfolio due to lower rates. With the share price at just $7.44, the stock trades at a huge discount to net asset value.
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 company recently declared its next distribution, which is in line with distributions paid monthly since early 2015. That was the last time PennantPark raised its payout, although to its credit, it hasn’t been cut, as has been the case with many other BDCs.
The stock has a very attractive annualized dividend yield above 15%. 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 has earned enough in core net investment income in recent periods to cover the dividend, including the recently-reported first quarter. Core net investment income was $0.30 per share against a quarterly distribution rate of $0.285 per share.
As a result, PennantPark’s payout ratio is very close to 100%. Of course, that is to be expected to an extent for a BDC, as they are required to distribute essentially all of their income.
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. But this could change, especially with average rates declining on its portfolio, and the prospect of a recession in the United States.
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 double-digit total returns on an annual basis from the yield alone. There is a possibility PennantPark’s net investment income will continue to grow, but rates are a headwind right now. 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 discount to net asset value and very high yield.