This Safe 10.1% Dividend Yield Could Go Even Higher When the Interest Rate Rises
The Best High-Yield Stock for 2018?
For investors looking for double-digit yielders in the current market, there are at least two important things to keep in mind: dividend safety and rising interest rates.
The first one is obvious. Dividend safety is of the utmost importance because, as income investors with a long-term horizon, we like to see dividend checks coming in at regular intervals. And, as history has shown us plenty of times, buying a high-yield stock before its dividend gets cut can turn into a very expensive lesson.
Now, why should yield-seeking investors also pay attention to rising interest rates?
Well, first of all, interest-bearing assets can sometimes compete with dividend-paying stocks. If bonds started paying more, dividend stocks may become less attractive.
Moreover, most companies carry some debt. So when interest rates rise, they might have to deal with a higher debt repayment burden, leaving less cash to be distributed to shareholders.
The good news is, I have found one company that can address these two issues: New Mountain Finance Corp. (NYSE:NMFC).
Most people have never heard of this name. However, the company offers a staggering double-digit yield and solid dividend safety, and it is well positioned to capitalize on the rising-interest-rate environment. Let me explain.
New Mountain Finance Corp. is a closed-end investment company headquartered in New York City. It invests mainly in middle-market companies in the U.S., which typically generate $10.0 million to $200.0 million in annual earnings before interest, tax, depreciation, and amortization (EBITDA).
The company’s focus is on senior secured lending. As of September 30, 2017, first-lien and second-lien debt accounted for approximately 79% of NMFC’s investment portfolio. (Source: “Q3 2017 Earnings Presentation,” New Mountain Finance Corp., last accessed January 26, 2018.)
Lending to middle market companies is highly profitable. Even though many of these businesses are already established and can generate recurring revenues and income, banks don’t usually lend to them. As a result, they need to pay higher financing costs, which allows New Mountain to earn a pretty high return on its investments.
By the end of September 2017, New Mountain’s portfolio had a weighted average yield of maturity at cost of 10.6%.
With an oversized stream of interest income from its loan portfolio, the company can pay a hefty dividend. Right now, New Mountain has a quarterly dividend rate of $0.34 per share, translating to an annual yield of 10.1%.
And thanks to the company’s focus on secured lending, the payout is safe. In the first nine months of 2017, approximately 90% of New Mountain’s total investment income was recurring. Moreover, the company’s investment income has covered its shareholder distribution for 18 consecutive quarters. (Source: “New Mountain Finance Corporation Announces Financial Results For The Quarter Ended September 30, 2017,” New Mountain Finance Corp., November 7, 2017.)
As for rising interest rates, note that around 85% of New Mountain’s interest-bearing assets are floating rate. On the liabilities side, more than half of its borrowings are fixed-rate. So when interest rates increase, the company would generate substantially higher interest income without incurring much higher interest expenses.
In fact, management has estimated that a 100-basis-point increase in interest rates would allow New Mountain to earn 7.9% higher interest income, net of interest expense. (Source: New Mountain Finance Corp., last accessed January 26, 2018, op cit.)
And because New Mountain chooses to be regulated as a business development company under the amended version of the Investment Company Act of 1940, it is required by law to distribute most of its profits to shareholders in the form of dividends. So, if interest rates increase (which they probably will) and the company earns higher net interest income, NFMC stock’s already-impressive 10.1% dividend yield could climb even higher.