3 High-Yield Stocks Under Pressure

By Jordan Wathen Markets Fool.com

Business development companies make money by making high-risk loans to businesses deemed too small for the public markets, and too risky for banks. By law, BDCs must pay out virtually all of their income, resulting in dividend yields that frequently run into the double digits.

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But the sky-high yields offered by PennantPark Investment (NASDAQ: PNNT), Fifth Street Finance (NASDAQ: FSC), and Medley Capital (NYSE: MCC) may be more indicative of outsize risk rather than opportunity. Here's why.

PIK me up

After resetting its quarterly dividend to $0.18 per share from $0.28, PennantPark Investment is now fully earning its dividend from operating income. The company recently reported operating income of $0.23 per share in its fiscal second quarter.

The quality of income is more important to me than the quantity of income, however. More than half (roughly 52%) of PennantPark Investment's operating income in its most recent quarter came from non-cash payment-in-kind (PIK) interest.

PIK interest is inherently low quality because it's earned when borrowers choose to roll interest into their balance rather than pay interest in cash. By law, BDCs must pay out virtually all of their income, including non-cash PIK income. PennantPark's non-cash income is growing as a percentage of its operating income, a worrying sign for investors.

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PennantPark's CFO, Aviv Efrat, addressed the issue in a response to an analyst's question on the company's conference call, saying that it's the company's goal to reduce the amount of PIK income it earns by exiting some of its PIK investments, or by restructuring some of its investments to generate more cash. That's certainly good news, as it isn't sustainable for any lender to pay out cash dividends based on non-cash income over the long haul. Investors will want to see that it follows through with this reasonable goal.

To be fair, a growing percentage of PIK income isn't even in the same neighborhood as the problems with the next two BDCs, which have issues that go far beyond the quality of their income sources.

When companies pay out all of their earnings, the dividend is always at risk of a cut. Image source: Getty Images.

On the cusp of another cut

Fifth Street Finance's poor underwriting record has resulted in tremendous losses for shareholders, as losses piled up in lender- and borrower-friendly periods alike. As rumors swirl that Fifth Street's external manager is for sale, investors also have every reason to worry that a new manager may ultimately prove to be as bad as, if not worse than, its existing management team.

All signs point toward the sale ofFifth Street Asset Management. Fifth Street Finance is prepaying some of its outstanding debt, paying down its SBA borrowings to $146 million, down from $210 million in the prior quarter. This is a step a BDC would take if it expected a change in control of its external asset manager.

Fifth Street Finance will pay a reduced dividend of $0.02 per share in June before paying a regular $0.125-per-share quarterly dividend in September, likely to preserve cash and make a larger dent in its liabilities ahead of a management change.

Asset quality is the perennial question at Fifth Street. The company revealed that 10% of its investment portfolio is currently underperforming initial expectations as of March 31. Its operating income of $0.13 per share in the most recent quarter only modestly covered its quarterly dividend of $0.125 per share, which will be paid in September.

If a new manager takes the helm at Fifth Street Finance later this year, it may have to make an unfavorable introduction by instituting yet another cut to the company's dividend.

A cut that wasn't deep enough

Medley Capital earned adjusted operating income of $0.17 per share in the most recent quarter, far below its $0.22 quarterly payout. To realign its payouts with its earnings power, the company slashed its dividend by 27% to $0.16 per share, per quarter. That cut may not have gone deep enough.

With a debt-to-equity ratio of 1.1, Medley may need to shrink the size of its investment portfolio to repay debt and lower its leverage, further weighing on its earnings going forward. Generally, BDCs try to hold leverage to less than 0.85 times their equity, a level that is generally held as the top of the leverage range for high-quality BDCs.

Problematic investments are numerous. Nearly 30% of Medley's investment portfolio is performing below expectations. In all, 13.8% of its investments are performing at a level at which there may be some loss of interest or dividend income, and/or the loss of principal.

When asked about whether Medley Management would be a potential acquirer of any BDC management contracts in the market today -- Fifth Street Finance's contract being one rumored for sale -- Medley Capital's CEO, Brook Taube, said that "I'm not in a position to comment on that question at this point in time. But we are aware of what's happening in the market."

With its premier BDC, Medley Capital, trading at a 31% discount to net asset value, could Medley Management really be in talks to run Fifth Street Finance, too?

The key takeaway: Dividend yields shouldn't be viewed in a vacuum. Investors who are enamored by outsize dividend yields should be aware of the risks, too.

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Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.