MCG Capital: Big Dividends From Small Loans

A stock with an 11.5% dividend yield sounds like a disaster in the making. But there are exceptions. For some years now, yields that high or close to it have been common in shares of "business development companies" (BDCs). These firms are second cousins to real estate investment trusts because they get big tax breaks as long as they pass nearly all of their earnings to the shareholders as dividends. And as long as the economy hums, well-run BDCs should have no trouble keeping up the good results.

BDCs borrow money from banks or other sources and then make small, short or medium-term loans (at much higher interest rates) to developing companies. Sometimes the terms of these loans give the BDC a minority ownership stake as well. The combination of profits from the spread on the BDC's interest dealings and the dividends or capital gains from its stakes in businesses produces the cash flow that turns into your dividends. Sometimes a BDC also benefits when one of its client companies is bought out for a higher price. The current boom in mergers and acquisitions is a favorable trend for the BDC industry.

Got all that? Well, then, need an idea? Consider MCG Capital (symbol MCGC), one of the standard-bearers in this field. It trades for $14.50 a share. This week, A.G. Edwards analyst Paul Hamilos upgraded MCG to a "buy" and set a target price of $16, citing an improved outlook for loan and earnings growth. MCG's dividend is 42 cents a quarter, or $1.68 a year, so the yield is between 11% and 12%. The Edwards upgrade pushed the stock up more than 4% on Wednesday, but it's still trading near its 52-week low.

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There is a speculative element here, and if you invest in BDCs, you need to be patient. For example, MCG shares doubled in value in 2003 and have dropped a few bucks ever since, but the dividends have stayed steady. Researchers at Friedman Billings Ramsey note that delinquencies in MCG's loan portfolio are low and falling, so the dividend outlook for the next year or two is secure.

BDC dividends aren't absolutely equivalent to payouts from standard stocks. Again, like REITs, most BDC income is taxable at ordinary rates instead of the 15% maximum rate on most dividends. That's because, like REITs, BDCs themselves aren't taxed on the money they pass through to you -- there is no "double taxation" of dividends. However, according to MCG's latest dividend release, about 30% of its payout does qualify for gentler tax treatment, either as capital gains or as nontaxable return of capital.

--Jeffrey R. Kosnett