1 Ultra-High Yield Dividend Stock You’ll Want to Keep on Your Radar as Rate Cuts Approach

VaselineSeptember 10, 2024

0 4 minutes read

1 Ultra-High Yield Dividend Stock You’ll Want to Keep on Your Radar as Rate Cuts Approach

It looks like the Fed will start cutting interest rates this month.

One of the most prominent themes of monetary policy over the past few years has been tight control over interest rates – and for good reason. In 2022 and 2023, the Federal Reserve raised interest rates 11 times in an effort to quell abnormally high levels of inflation.

Although inflation persists, the current level of 2.9% has cooled significantly from its high points in the summer of 2022. The current picture of unemployment data and inflation trends has many economists predicting that rate cuts may finally be on the horizon . Even Fed Chairman Jerome Powell strongly hinted that policy changes are imminent in a speech he gave in Jackson Hole, Wyoming a few weeks ago.

There are many types of businesses that could benefit from interest rebates. In particular, I looked closely at business development companies (BDCs). Let’s unravel the underbelly of BDCs and look at the ultra-high-yield BDC stock I have on my radar right now.

What are business development companies?

BDCs are quite interesting. Essentially, they are providers of capital to early-stage businesses seeking funding to start their operations. In addition, some BDCs such as Ares Capital, offer more sophisticated financing solutions – making them attractive to larger public companies as well.

You might be wondering if a BDC is just a fancy term for a bank. Well, not exactly.

BDCs have an unusual appearance corporate structure where 90% of taxable income is distributed to shareholders on an annual basis. For this reason, BDCs tend to be favorites for those looking for dividend income.

The chart below illustrates the dividend payouts for Hercules over the last 10 years. For the most part, Hercules has not only consistently paid a dividend, but has also increased its quarterly and supplemental dividend payments. The notable exception was a brief reduction in the additional dividend in early 2020 at the start of the COVID-19 pandemic (seen in the gray shaded column).

HTGC Dividend Data by YCharts.

However, not all BDCs are created equal — far from it. Many BDCs focus on specific sectors, which makes the risk profile of each portfolio very different. Furthermore, underwriting protocols vary from company to company. For this reason, it is very important to look at the overall performance of a BDC’s operation to gauge the strength of its portfolio and get an idea of its credit controls.

Image source: Getty Images.

And the BDC I have on my radar is…

One BDC that I think is particularly well positioned to benefit from rate cuts is The capital of Hercules (HTGC 0.27%). Hercules is a BDC that focuses on emerging themes in technology, life sciences and green energy. It specializes in venture debt, making high-yield loans to companies that have previously raised external venture capital or private equity funds.

Given that Hercules lends money to relatively early-stage businesses, you might think its risk profile is pretty high. But I don’t really see it that way. One metric I like to use to gauge the health of a BDC is Net Investment Income (NII). NII can be helpful when evaluating the profitability of an investment firm. The table below reflects the NII for Hercules over the last few years.

Category 2018 2019 2020 2021 2022 2023 Six months ended June 30, 2024

Net investment income per share $1.19 $1.41 $1.39 $1.29 $1.48 $2.09 $1.01

Data source: Hercules Investor Relations.

Since 2018, Hercules’ NII has been steadily increasing, which I believe serves as a good barometer of management underwriting and portfolio management. Moreover, Hercules has consistently rewarded shareholders in the form of increased dividend payouts in tandem with NII growth.

Why do I see Hercules as a jerk right now

A cut in interest rates could benefit Hercules in several ways.

Over time, it becomes less attractive for founders to consistently raise capital from venture capital (VC) firms. Because VCs acquire equity in the businesses they invest in, the opportunity cost of each subsequent capital raise is diluted for founders and even employees. As a result, business leaders are inclined to allocate capital with caution and prudence, with the intention of achieving break even or positive free cash flow.

Of course, lower interest rates (cheaper debt) could be particularly attractive to venture capital-backed companies that have proven they are no longer cash-intensive operations but still seek access to external financing, such as a term or revolving loan. credit facility. Because the debt is not dilutive, Hercules could be an attractive option in situations like these, which could lead to a new wave of demand for its services.

I’m not too worried about competition from private credit providers in this space either. I think Hercules offers a level of flexibility that most traditional banks just aren’t willing to offer. A middle market business may be turned down by a bank or may not be able to get as large a loan as they are looking for.

Hercules differentiates itself from these firms by providing access to larger sources of capital, but at the same time protects itself by attaching covenants to its deal structures. Moreover, Hercules has a unique opportunity to form strong relationships with the venture capitals that back many of its portfolio companies. This can lead to repeat business in the form of refinancing within the portfolio or referral transaction flow.

For these reasons, I am optimistic that Hercules will continue to generate strong growth and will be able to maintain and increase its dividend payments over the long term.

In addition, a reduction in interest rates can also lead to excess capital that would otherwise be directed towards higher interest payments. This could indirectly benefit Hercules as its portfolio companies could begin to re-accelerate growth initiatives, leading to higher valuations over time.

Finally, because corporations often borrow money to finance big-dollar deals, cheaper debt could inspire some companies to reevaluate more strategic opportunities such as mergers and acquisitions. Such liquidity events could be beneficial to Hercules as some of its portfolio companies could end up being acquired by larger enterprises. Moreover, since Hercules often attaches warrants to its investments, I see the potential for upside acquisitions as particularly lucrative.

HTGC Total Return Level data by YCharts.

As of this writing, Hercules has a dividend yield of 10.4% — nearly 8 times the dividend yield SPDR S&P 500 ETF Trust. Additionally, the stock’s five-year total return of 152% easily beats that of S&P 500.

Given the stock’s consistent performance, along with its ultra-high yield and position to benefit from potential interest rate cuts, I see Hercules as a no-brainer opportunity right now.