One in all the outstanding themes of monetary policy over the last few years is an intense scrutiny on rates of interest — and for good reason. In 2022 and 2023, the Federal Reserve hiked rates of interest 11 times in an effort to stifle abnormally high levels of inflation.

Although inflation still persists, the current level of two.9% has materially cooled from its high points in the midst of the summer of 2022. The current picture surrounding unemployment data and inflation trends has many economists forecasting that rate cuts may finally be on the horizon. Even Fed Chair Jerome Powell strongly suggested that changes in policy were imminent in a speech he gave in Jackson Hole, Wyoming just a few weeks ago.

There are a number of forms of companies that will profit from reductions in rates of interest. Particularly, I actually have been looking closely at business development corporations (BDCs). Let’s break down the ins and outs of BDCs and have a take a look at the ultra-high-yield BDC stock I even have on my radar immediately.

What are business development corporations?

BDCs are pretty interesting. At their core, they’re capital providers to early-stage businesses looking for funding to get their operations off the underside. Furthermore, some BDCs, much like Ares Capital, offer more sophisticated financing solutions — making them appealing to larger public corporations as well.

You is maybe wondering if a BDC is only a flowery term for a bank. Well, not exactly.

BDCs have an unusual corporate structure in that 90% of taxable income is distributed to shareholders on an annual basis. For this reason, BDCs are more likely to be a favorite for those looking for dividend income.

The chart below illustrates the dividend payments for Hercules over the past 10 years. For probably essentially the most part, Hercules has not only consistently paid a dividend, nonetheless it’s also raised its quarterly and supplemental-dividend payments. The notable exception was a brief cut to the supplemental dividend in early 2020 at first of the COVID-19 pandemic (seen throughout the grey-shaded column).

Nonetheless, not all BDCs are created equal — faraway from it. Many BDCs focus on specific sectors, making the possibility profile of each portfolio vastly different. Moreover, underwriting protocols vary from one company to the next. For this reason, it’s totally vital to have a take a look at the final performance of a BDC’s operation in order to gauge the strength of its portfolio and get a way of its credit controls.

And the BDC I even have on my radar is…

One BDC that I feel is particularly well positioned to learn from rate cuts is Hercules Capital (NYSE: HTGC). Hercules is a BDC that focuses on emerging themes in technology, life sciences, and green energy. It focuses on enterprise debt, making high-yield loans to corporations which have previously raised outside funding from enterprise capital or private equity.

Considering that Hercules is lending money to relatively early-stage businesses, it’s possible you’ll think its risk profile is kind of high. But I don’t quite see it that way. One metric that I prefer to make use of to measure a BDC’s health is net investment income (NII). NII is likely to be helpful when assessing an investment firm’s profitability. The table below reflects NII for Hercules over the past several years.

Data source: Hercules Investor Relations.

Since 2018, Hercules’ NII has consistently increased, which I feel serves as a excellent barometer of management’s underwriting and portfolio management. Moreover, Hercules has consistently rewarded shareholders in the form of raising dividend payments in tandem with its increasing NII.

Why I see Hercules as a no brainer immediately

A reduction to rates of interest may profit Hercules in several ways.

Over time, it becomes less appealing for founders to consistently raise capital from enterprise capital (VC) firms. Because VCs acquire equity in the businesses that they spend money on, the possibility cost of each subsequent capital raise is dilution to founders and even employees. Consequently, business leaders are inclined to allocate capital prudently and cautiously, with the intention of reaching breakeven or positive free money flow.

Actually, lower rates of interest (cheaper debt) is likely to be particularly appealing to venture-backed corporations which have proven they’re not high-cash-burn operations but are still in quest of access to outside funding, much like a term loan or a revolving credit facility. Since debt is non-dilutive, Hercules is likely to be a sexy option in situations like these, which can result in a modern wave of demand for its services.

I’m not overly nervous about competition from private credit providers on this space, either. I feel Hercules offers a level of flexibility that almost all traditional banks simply aren’t willing to produce. A middle-market business may be turned away from a bank or won’t offer you the possibility to get as high of a loan since it’s looking for.

Hercules differentiates itself from these firms by offering access to larger sources of capital, yet concurrently protects itself by attaching covenants to its deal structures. Moreover, Hercules has a singular opportunity to form strong relationships with the VCs that back a number of its portfolio corporations. This could result in repeat business in the form of refinancing contained in the portfolio or referral-deal flow.

For these reasons, I’m optimistic that Hercules will proceed generating strong growth and offer you the possibility to maintain up and lift its dividend payments over a long-run time horizon.

In addition to, a reduction to rates of interest may end in excess capital that can otherwise be geared toward higher interest payments. This might indirectly profit Hercules, as its portfolio corporations could start reaccelerating growth initiatives, leading to higher valuations over time.

Lastly, since corporations often borrow money to fund large-dollar transactions, cheaper debt could encourage some businesses to reevaluate more strategic opportunities, much like mergers and acquisitions. Such liquidity events is likely to be useful for Hercules, as just a few of its portfolio corporations could end up becoming acquired by larger enterprises. Moreover, because Hercules often attaches warrants to its investments, I see the potential for rising acquisitions as particularly lucrative.

As of this writing, Hercules carries a dividend yield of 10.4% — nearly 8 times the dividend yield of the SPDR S&P 500 ETF Trust. On top of that, the stock’s five-year total return of 152% handily trounces that of the S&P 500.

Considering the stock’s consistently strong performance, coupled with its ultra-high yield and position to learn from potential rate of interest cuts, I see Hercules as a no brainer opportunity immediately.

Do you could have to take a position $1,000 in Hercules Capital immediately?

Before you buy stock in Hercules Capital, consider this:

The Motley Idiot Stock Advisor analyst team just identified what they imagine are the 10 best stocks for investors to buy now… and Hercules Capital wasn’t one in every of them. The ten stocks that made the cut could produce monster returns within the approaching years.

Consider when Nvidia made this list on April 15, 2005… when you occur to invested $1,000 on the time of our suggestion, you’d have $630,099!*

Stock Advisor provides investors with an easy-to-follow blueprint for success, including guidance on constructing a portfolio, regular updates from analysts, and two latest stock picks every month. The Stock Advisor service has greater than quadrupled the return of S&P 500 since 2002*.

See the ten stocks »

*Stock Advisor returns as of September 9, 2024

Adam Spatacco has no position in any of the stocks mentioned. The Motley Idiot has no position in any of the stocks mentioned. The Motley Idiot has a disclosure policy.

1 Ultra-High-Yield Dividend Stock You could Have to Have on Your Radar as Rate Cuts Loom was originally published by The Motley Idiot