The Fed’s zero-interest-rate policy has forced investors looking for income to turn to the stock market. The dividend-related buying has pushed the prices of many traditional income stocks beyond what’s justified by their fundamentals. And many common income alternatives (real estate investment trusts (REITs), for example) have become overpriced as investors buy stocks with less-than-wonderful fundamentals to secure a dividend flow.
What’s an investor to do?
Well, shrewd yield-hungry buyers have discovered a previously little-discussed segment of the market known as business development companies (BDCs).
These are closed-end funds that have proliferated in the aftermath of the credit crisis. These funds make loans and equity investments to middle-market companies that have found bank lending difficult to obtain as banks have become more risk-averse; BDCs are able to make the loans the banks will not and fill a financing void in the US business community.
They operate much like a private-equity — in fact, many of them are actually sponsored by leading private-equity shops. They tend to have very high yields and can be an attractive addition to an income portfolio. As with everything else it is important to use Portfolio Grader to make sure we only buy into the very best BDC investments.
I used the stock grading tool to search the universe of BDC opportunities and have found two that have the best-of-the-best characteristics we want in our income portfolios. Compass Diversified Holdings (CODI) invests directly in the type of companies usually owned by very wealthy individuals or private-equity firms. They own a portfolio of companies with strong brands that produce high levels of free cash flow. The company pays out that cash flow to shareholders; the stock currently yields around 8%. Compass has never lowered its payout — not even during the somewhat difficult year of 2009 when many BDCs had to reduce payouts. The fundamentals have improved rapidly and the stock has been upgraded twice this year. This week it was raised to “A” by Portfolio Grader and is now a “strong buy.”
TCP Capital Corporation (TCPC) is also a high-rated BDC offering that uses a slightly different approach. Rather than equity stakes, the company makes loans to middle-market companies across a wide range of industries. Most of their loans are senior in the capital structure and almost 70% of them have floating rates. The company has a $510 million loan portfolio with an average yield of a little over 11%. Once expenses and costs are paid, the payout to shareholders is currently more than 9%. Like Compass, the stock was upgraded to an “A” this week and is a “strong buy” as measured by Portfolio Grader.
The search for yield is a critically important task for many investors. BDC investments can be a strong addition to an income portfolio — but be sure to use a robust screener tool like Portfolio Grader to find the very best opportunities in this sector.
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