1 High-Yielding Dividend Stock You Should Keep On Your Radar As Interest Rate Cuts Approach

The Federal Reserve looks likely to start cutting interest rates this month.

One of the most prominent monetary policy themes of the past few years has been intense control over interest rates — and with good reason. The Federal Reserve has raised interest rates 11 times in 2022 and 2023 to tamp down abnormally high levels of inflation.

While inflation is still holding up, the current level of 2.9% is down significantly from the summer 2022 highs. The current picture of unemployment data and inflation trends has many economists predicting that interest rate cuts could eventually be on the horizon. Even Fed Chairman Jerome Powell strongly suggested that policy changes were inevitable in a speech he gave in Jackson Hole, Wyoming, a few weeks ago.

There are many types of companies that could benefit from lower interest rates. In particular, I’ve been keeping a close eye on business development companies (BDCs). Let’s break down BDCs and take a look at the ultra-high-yield BDC stocks that are currently on my radar.

What are business development firms?

BDCs are quite interesting. At their core, they are providers of capital to early-stage companies that are looking for funding to get their business off the ground. Additionally, some BDCs, such as Ares Capital, offer more advanced financial solutions, which makes them attractive also for larger public companies.

You may be wondering if BDC is just a fancy word for bank. Well, not really.

BDCs have an extraordinary a corporate structure in which 90% of taxable income is distributed to shareholders annually. For this reason, BDCs are typically a favorite choice for those seeking dividend income.

The chart below illustrates Hercules’ dividend payments over the past 10 years. In most cases, Hercules has not only consistently paid its dividend, but has also increased its quarterly and supplemental dividend payments. A notable exception was a brief cut to the supplemental dividend in early 2020 at the onset of the COVID-19 pandemic (shown in the gray column).

HTGC dividend data by YCharts.

However, not all BDCs are created equal – quite the opposite. Many BDCs focus on specific sectors, which makes the risk profile of each portfolio very different. In addition, underwriting protocols vary by company. For this reason, it is very important to look at the overall performance of a BDC to assess the strength of its portfolio and get a sense of credit control.

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 lower interest rates is Hercules’ Capital (HTGC 0.27%). Hercules is a BDC focused on emerging themes in technology, life sciences, and green energy. It specializes in high-risk debt, providing high-yield loans to companies that have previously raised external financing from venture capital or private equity.

Given that Hercules is lending money to relatively early-stage companies, you might think its risk profile is pretty high. But I don’t see it that way. One metric I like to use to measure the health of a BDC is net investment income (NII). NII can be helpful in assessing the profitability of an investment firm. The table below shows Hercules’ NII over the past 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 dollars

Data source: Hercules Investor Relations.

Hercules’ NII has been rising steadily since 2018, which I believe is a good barometer of management’s underwriting and portfolio management. In addition, Hercules has consistently rewarded shareholders by increasing dividend payouts in tandem with its rising NII.

Why I think Hercules is the obvious choice right now

A reduction in interest rates could bring several benefits to Hercules.

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

Of course, lower interest rates (cheaper debt) may be particularly attractive to venture-backed companies that have proven they are no longer cash-intensive operations but still seek access to external financing, such as a term loan or revolving credit. Because debt is non-dilutive, Hercules may be a tempting option in such situations, which could lead to a new wave of demand for its services.

I’m also not too concerned about the competition from private lenders in this space. I think Hercules offers a level of flexibility that most traditional banks simply don’t want to offer. A mid-market company might be rejected by a bank or not be able to get the big loan they’re looking for.

Hercules stands out from these firms by offering access to larger sources of capital while also protecting itself by including covenants in its deal structures. In addition, Hercules has a unique opportunity to build strong relationships with VCs that support multiple portfolio companies. This can result in repeat business in the form of portfolio refinancing or reference deal 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 payout over the long term.

In addition, lower interest rates could also result in excess capital that would otherwise be allocated to higher interest payments. This could indirectly benefit Hercules as its portfolio companies could begin to accelerate growth initiatives, leading to higher valuations over time.

Finally, because corporations often borrow money to finance large-scale transactions, cheaper debt could inspire some companies to reassess more strategic opportunities, such as mergers and acquisitions. Such liquidity events could be beneficial for Hercules, as some of its portfolio companies could be acquired by larger companies. Additionally, because Hercules often includes rights issues with its investments, I believe the potential for growing acquisitions is particularly lucrative.

HTGC Total Return data by YCharts.

At the time of writing, Hercules has a dividend yield of 10.4%, which is almost 8 times the company’s dividend yield SPDR S&P 500 ETF FundWhat’s more, the stock’s five-year total return of 152% clearly exceeds the stock’s return S&P500.

Given the stock’s consistently high profitability, as well as its extremely high yield and the ability to benefit from potential interest rate cuts, I believe that investing in Hercules is an obvious opportunity right now.