High Yield Income: Secure Stellus Capital’s 8.4% Yield (NYSE:SCM)

Stellus Capital Investment Corporation (NYSE:SCM) is a well-managed business development firm with a solid debt portfolio comprised primarily of First Liens.

The BDC provides high-yielding dividend income that is offset by net investment income and floating-rate exposure to investors.

Stellus Capital’s stock is still trading at a slight discount to net asset value, and the BDC recently declared special dividend payments to distribute excess portfolio income.

Taking A Look At Stellus Capital’s Investment Strategy And Portfolio

Stellus Capital is a traditional business development company, which means it seeks to make primarily debt investments in private companies with annual EBITDA of $5 million to $50 million.

The primary focus is on Senior Secured First Liens and Second Liens, which have a low loss ratio and a high probability of performing well even during stressful economic contraction periods.

The debt portfolio of Stellus Capital has two characteristics that passive income investors will appreciate.

To begin, the portfolio is geared toward high quality (low risk) First Liens that are highly secured (92% of the assets of the business development company are invested in First Liens), while 7% are invested in Second Liens.

Like many other BDCs, the company has less than 1% of its assets invested in unsecured debt and none in equity. Equity investments are frequently used to add a return lever to a debt-heavy investment portfolio, but they also add risk.

Second, Stellus Capital has invested 97% of its funds in floating rate loans, allowing the BDC to earn higher net interest income in a rising-rate environment.

Inflation has begun to moderate recently, but it remained high in October, at 7.7%, implying that the central bank will most likely continue to raise interest rates to help consumers combat inflation. This will allow Stellus Capital to generate more net interest income from its loan portfolio and may result in a lower pay-out ratio in the future.

The BDC Covers Its Dividend With Net Investment Income

Stellus Capital earned $0.35 in core net investment income in the third quarter, outperforming regular dividend distributions of $0.28 per share by 7 cents.

Stellus Capital’s dividend pay-out ratio was 80% in the third quarter, down from 89% in the previous year. The pay-out ratio is calculated using only the regular dividend of $0.28 per share, which is paid monthly at $0.0933.

Furthermore, Stellus Capital announced the payment of $0.02 per share per month in special dividends, in addition to the regular $0.0933 monthly dividend, due to strong portfolio performance.

The BDC pays an 8.1% stock yield based solely on its regular monthly dividend payment of $0.0933 per quarter.

If Stellus Capital decides to pay a special dividend of $0.02 per month for the next year, the yield could rise to 9.9%.

Price to Net Asset Value

Stellus Capital’s stock trades at a 4% discount to net asset value, implying a narrow margin of safety. Last time I wrote about it, the stock was trading at a 9% discount to net asset value.

Why Stellus Capital Could See A Lower/Higher Valuation

Stellus Capital prioritizes safety and employs a disciplined approach to credit risk management. Having said that, even the highest rated and secured debt available to debt investors, First Liens, are debt investments that can go bad if the investment climate deteriorates.

Despite an over-weighting of First Liens, a recession could result in Stellus Capital’s portfolio quality deteriorating, leading to investment losses and a lower net asset value (higher NAV discount).

Given that the BDC’s dividend is covered by NII, I believe Stellus Capital could trade at a premium to net asset value in the short term.

My Conclusion

Stellus Capital is an appealing business development firm with a disciplined investment focus that focuses primarily on the highest-interest-rate debt types: First Liens. The BDC also avoids equity investments, which may provide higher returns but also pose a higher risk to the investment portfolio.

Stellus Capital easily covered its dividend payment with net investment income in the third quarter.

If Stellus Capital continues to pay a $0.02 per month special dividend to distribute excess portfolio income over the next year, the BDC’s dividend yield could rise to 9.9% for passive income investors.