Last week, I stunned myself by giving Seadrill (Nasdaq: SDRL), a stock with a yield above 11%, an “A” rating for dividend safety. Usually, when I see a double-digit yield, my spidey senses tingle, telling me there is something to be cautious about.

This week, I’m reviewing Prospect Capital Corp. (Nasdaq: PSEC) and its payout, as suggested by Lloyd.

Prospect is a business development company (BDC) that yields 12.2%. BDCs take equity positions or lend money to usually private small to mid-size businesses.

[ad#Google Adsense 336×280-IA]The publicly traded BDCs typically pay a high dividend yield as they collect monthly income from their loans, which carry higher interest rates than a bank loan.

Before we analyze the safety of the dividend, understand that share prices of BDCs could be volatile over the next few months as S&P, Dow Jones and Russell announced they are removing BDCs from various stock indexes.

This does not affect the fundamentals of the BDCs’ businesses, so it’s simply a matter of market mechanics.

After the BDCs are removed from the indexes, they should go back to trading according to their fundamentals.

Dividends Through September
Prospect Capital pays a monthly dividend. It has already announced the dividends will be $0.11 per share through September. That is the same amount it’s paid in dividends since December 2012. For the three years prior to that, the company paid a monthly dividend of $0.10 per share. It did cut dividends in 2010, when it paid $0.41 per quarter. On a monthly basis that would equal nearly $0.14.

Before the Great Recession, Prospect had a solid track record of a stable or rising dividend from 2005 to 2010. So other than during economic collapse, its dividend history has been solid.

The company recently borrowed $300 million, with an interest rate of 5%. It should be able to lend that money, generating more interest income and possibly raising the dividend in the future.

Through the first two fiscal quarters of the year (its fiscal year ends in September), the company generated $0.64 per share in net investment income – the BDC equivalent of cash flow – while paying out $0.66 in dividends.

In fiscal 2013, the company generated $1.05 per share in net investment income while paying $1.28 in dividends. The prior year, net investment income of $1.66 was more than enough to pay the $1.22 in dividends. And in 2011, the $1.37 in net investment income also eclipsed the $1.18 in dividends.

I’d like to see net investment income rise above the dividend to feel 100% confident that there is no chance of a dividend cut.

But as I said, the money that the company just raised should generate more income once it’s deployed.

Additionally, a rise in interest rates will boost Prospect’s income.

The company stated that a 5% increase in rates would add another $0.09 in net investment income.

Given the company’s track record and the extra cash that is going to be put to work, I don’t see any problems with the dividend in the near future.

Should we get another year of net income below the dividend, we’ll have to re-examine, but I’d be surprised if that winds up being the case.

For now, the dividend is safe.

Dividend Safety Rating: A

— Marc Lichtenfeld

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Source: Wealthy Retirement