Business development companies can be a lucrative source of passive income.
One of the key ingredients in a diversified investment portfolio is dividend stocks. Passive income can be helpful for investors looking to supplement any gains they might have from growth stocks. Retirees in particular can benefit from earning some extra cash that’s essentially free.
Business development companies (BDC) can be particularly good sources of dividend income, paying above market returns. Let’s explore three BDCs that offer some juicy dividend yields and assess why now is as good a time as ever to scoop up some shares.
1. Hercules Capital: 9.5% dividend yield
Hercules Capital (HTGC 0.55%) specializes in high-yield loans to start-ups that have raised funding from venture capitalists in the technology, healthcare, and energy sectors. Hercules’ portfolio includes DNA test provider 23andMe, electronic-signature specialist Docusign, online sports betting site FanDuel, and ride-hailing service Lyft.
One of the aspects of Hercules’ deal structures that I like is that it often negotiates for warrants that can convert into equity as part of its transactions. This lets Hercules benefit from some of the upside of a liquidity event for one of its portfolio companies, such as an initial public offering or a sale.
HTGC price-to book-value; data by YCharts.
One drawback for Hercules is valuation. As shown above, Hercules has a price-to-book-value (P/B) ratio of 1.7 — well above any of its peers. I would said the company’s premium valuation is warranted, though.
In the company’s latest quarterly filing, Hercules reported a nonaccrual rate of just 1.2%. Essentially, this means that only 1.2% of Hercules’ entire portfolio is not able to meet principal and interest payments on their loans. Considering its portfolio is in excess of $3 billion, I would not worry about such a nominal nonaccrual rate.
Despite its rich price tag compared to the competition, Hercules appears to be a winner among BDCs, and its 9.5% dividend yield looks awfully tempting right now.
Image source: Getty Images.
2. Horizon Technology: 11.2% dividend yield
Horizon Technology Finance (HRZN -0.17%) is comparable to Hercules in that it also specializes in high-yield term loans to technology and life-sciences businesses.
One of the starkest differences between Hercules and Horizon is the rate at which each is growing. During the first quarter of 2024, Hercules generated net investment income (NII) of $79 million, an increase of 21% year over year. This growth is how Hercules is able to fund a wide array of businesses and strengthen its overall portfolio.
By comparison, Horizon reported just $12.6 million in NII during the first quarter — little changed year over year. Considering the company’s growth has remained muted, it’s not surprising to see that Horizon did just five deals in the first quarter for a total of $33 million.
With such mundane growth, why do I see Horizon as a compelling buy?
For starters, the stock is down more than 10% so far in 2024. Although the sell-off might be warranted, I think the company’s valuation disparity compared to Hercules is pretty wide.
Moreover, I think Horizon is a good opportunity for dividend reinvestment.
Over a longer time frame, investors can see in the chart below, Horizon has a total return of nearly 140%. This means that if you had invested $10,000 a decade ago, you would have more than doubled your money by holding on to Horizon shares and reinvesting your dividends.
While the stock itself might carry some volatility due to the company’s inconsistent performance, two things have remained consistent in the long run: Horizon continues to pay a generous dividend, and reinvesting this income has paid off for long-term shareholders.
HRZN total return level; data by YCharts.
3. Ares Capital: 9.3% dividend yield
The last BDC on my list, Ares Capital (ARCC 0.24%), is quite different from Hercules and Horizon.
The company does not generally work with technology start-ups or businesses backed by venture capital. Instead, Ares has its eyes on middle-market opportunities.
There are many companies in need of capital or advisory services, but they are not big enough or deemed suitable by investment banks. This is where Ares comes into the equation.
It has built a strong reputation working with middle-market companies across all industry sectors, offering complex deal structures including leveraged buyouts, acquisitions, growth capital, and restructurings.
Like Hercules, Ares also has a low nonaccrual rate of just 1.7%.
Data source: Ares Capital.
As seen in the slide above, the most compelling aspect about an investment in Ares is the company’s performance during the past couple of years. In that time, it has generated superior total returns compared to many of its peers and even the broader market.
At a modest P/B of just 1.1 and a 9.3% dividend yield, Ares looks like a great opportunity for dividend investors right now.