A High-Yield Sector Most People Have Never Heard Of
Banks are one of my favorite types of businesses. They lend money to customers at higher interest rates than they borrow at, pocketing the difference, called the “spread.” This simple but profitable business model has been working well for centuries and allows banks to earn massive profits to this day.
So, where do banks’ profits go?
Well, certainly not to the customers who deposited their money at the bank. Even after five interest rate hikes from the U.S. Federal Reserve, a typical savings account at one of the major banks in the U.S. still pays next to nothing.
The profits go to the owners of banks: the shareholders. But, because bank stocks are such popular investments, people have been buying them left, right, and center. As a result, shares of the most well-known U.S. banks have gotten expensive. And since dividend yield moves inversely to share price, the surging banking sector no longer offers attractive yields. For instance, Bank of America Corp (NYSE:BAC) pays 1.6%, while Wells Fargo & Co (NYSE:WFC) yields three percent.
However, that doesn’t mean there’s no way for yield-seeking investors to benefit from the banking business model. In particular, there is a niche lending market that is known for its profitability. But because most people have never heard of it, companies operating in that market can still offer pretty substantial yields.
I’m talking about the U.S. middle market, which, as the name suggests, is made up of companies larger than small businesses but smaller than large corporations. There’s no absolute rule on the exact size a business has to be in order to qualify as a middle-market company. Some analysts use a range of $10.0 million to $500.0 million in revenue, while others set the upper limit at $1.0 billion.
The key to note here is that many middle-market businesses have financing needs. In the past, they could just go to a bank and get a loan. But in recent years, due to the more restrictive regulatory environment and consolidation in the banking system, commercial banks have shifted away from the middle market to focus more on large corporations. 20 years ago, banks were making more than 70% of all the loans given to middle-market businesses; today, they represent just 10% of middle-market lending. (Source: “Investor Presentation,” Medley Management Inc, last accessed April 4, 2018.)
In other words, today’s middle-market companies can’t just go to a bank and get a loan. As a result, they have to pay higher interest rates to obtain financing.
And that has created an opportunity for a group of companies that I call “alternative banks.” Unlike traditional banks, these alternative banks don’t offer branches or ATMs for their customers. Instead, they specialize in lending to middle-market businesses, collecting oversized interest income by doing so.
So what exactly are these “alternative banks?” To put it simply, an alternative bank is a business development company (BDC). BDCs were created by the U.S. Congress in 1980 to fuel job growth and help middle-market businesses obtain financing. Because shares of many BDCs trade on major stock exchanges, regular investors can get a piece of the action too.
To acquire BDC status, a company must meet a list of requirements, such as investing at least 70% of its total assets in U.S. businesses with market values of under $250.0 million. Moreover, BDCs are required by law to distribute more than 90% of their profits to shareholders in the form of dividends.
Combining a profitable middle-market lending business with the mandatory distribution requirement, BDCs have become some of the highest-yielding companies in today’s stock market.
Below, I have compiled a list of three “alternative banks” yielding up to 15.8%.
List of 3 High-Yield “Alternative Banks”
| Company Name | Stock Exchange | Ticker Symbol | Dividend Yield |
| Main Street Capital Corporation | NYSE | MAIN | 6.1% |
| Horizon Technology Finance Corp | NASDAQ | HRZN | 11.4% |
| Medley Capital Corp | NYSE | MCC | 15.8% |
Main Street Capital Corporation
Commanding a market capitalization of over $2.0 billion, Main Street Capital Corporation (NYSE:MAIN) is one of the larger BDCs in the market. Its size allows it to have a well-diversified portfolio, with investments in 186 companies coming from more than 30 different industries. (Source: “Investor Presentation,” Main Street Capital Corporation, last accessed April 4, 2018.)
Most bank stocks pay quarterly dividends. Main Street Capital, on the other hand, distributes every month. With a monthly dividend rate of $0.19 per share, MAIN stock offers an annual yield of 6.1%.
The yield itself may not look that exciting, but note that this “alternative bank” also makes supplemental dividend payments from time to time. As a matter of fact, Main Street Capital has paid special dividends to shareholders every year since 2013. (Source: “Dividends,” Main Street Capital Corporation, last accessed April 4, 2018.)
Horizon Technology Finance Corp
The technology sector is not known for its dividends, but lending to tech companies can return a tremendous amount of value to income investors.
Case in point: Horizon Technology Finance Corp (NASDAQ:HRZN) is a BDC that provides financing solutions to companies in the technology, life science, healthcare information and services, and cleantech industries. Most of the money is lent out through senior-term loans secured by first lien. This means, if anything goes wrong, Horizon will stand first in line to get paid.
By the end of 2017, Horizon’s debt portfolio consisted of 33 secured loans with an aggregate fair value of $203.8 million. The company earned a 15.1% yield from its loan portfolio last year. (Source: “Horizon Technology Finance Announces Fourth Quarter and Full Year 2017 Financial Results,” Horizon Technology Finance Corp, March 6, 2018.)
Thanks to a high-yield loan portfolio, Horizon has established a generous dividend policy. Paying $0.10 per share on a monthly basis, HRZN stock has an annual yield of 11.4%.
Medley Capital Corp
With a jaw-dropping yield of 15.8%, Medley Capital Corp’s (NYSE:MCC) payout dwarfs most dividend-paying stocks in today’s market. The company lends to middle-market businesses primarily through directly originated transactions. By the end of 2017, Medley Capital had investments in 68 portfolio companies, with more than two-thirds of those investments made up of senior secured first-lien loans. (Source: “Investor Presentation,” Medley Capital Corp, last accessed April 4, 2018.)
Going forward, the company is well positioned to capitalize on the rising interest rate environment. Approximately 84% of the loans in Medley Capital’s portfolio bear interest at floating rates. So if interest rates increase, the company would generate higher interest income from its portfolio.