1 Big Risk Investors Are Missing in This High-Yield Industry

The best financiers and bankers aren't worried about what they'll make. They're worried about what they can lose.

When capital is cheap like it is today, greed can get the best of anyone. For investors who own high-yield business development companies like Apollo Investment and Triangle Capital , this risk is especially large.

But everything is rosy!
It is. Right now.

When we think of companies that make money by lending money, it's important to remember that the losses tend to come in pairs, triples, and quintuples. If one loan is written off, you can expect several others to follow. Finance is as cyclical as any business. Find a grey-haired banker and ask him about how many times he or she has seen a layoff.

When I think about private equity and business development companies, I spend a lot of time thinking about credit quality and availability. Two things grab most of my attention.

1. Can these loans pay off without refinancing?
Warren Buffett famously said that "only when the tide goes out do you discover who's been swimming naked." Awash in liquidity, some high-yield BDCs are probably swimming naked, but there's little evidence that we can see now.

The important thing in lending is getting your money back. With rates dropping for much of the last five years, private equity investors have raised piles of money. And their customers -- borrowers -- have been tapping them for cash frequently.

Here's the rub: Even a terrible business can repay a loan as long as someone else is willing to float them money. You can run a great loan book even if your borrowers are losing money and can merely afford interest payments. All you need is someone else to take up the loan when it comes time to refinance. Most people don't think like that, but it's true -- it's why lending can become a true house of cards when the seas of cash retreat.

2. Hopping off at floor 13
Keeping in mind point No. 1, that a business can repay loans just by refinancing and by virtue of the Greater fool (hopefully not us Fools), I begin to think about the next credit crunch. In leveraged lending and middle-market private equity, that big risk is, in my mind, what happens when the Fed tapers its asset purchases.

The Fed's buying sprees don't just magically drive down interest rates. It increases the supply of liquidity -- the money available for lending.

When credit gets tight, it's not going to be the S&P 500 companies of the world that feel the pinch. It's going to be the borrowers at the margin -- the higher-risk, smaller companies that Apollo Investment and Triangle Capital fund.

Can you pick the top? It's unlikely. Right now, deals are getting done with worsening protections for the lender. Financial Times reports that covenant-lite deals have surpassed their financial crisis peak.

Admittedly, leveraged loans are for larger businesses than BDCs invest in, so it's not a perfect proxy of risk. But it's obviously not a good sign, either.

I'm not telling you to run for the hills now. I don't think anyone can truly predict a top in private equity. But if history is indication, it tends to happen in times like right now -- when private companies are going public, covenant-lite loans are expanding, and managers are loaded with cash.

I just want to deliver a reminder that not every year will be a year of luscious dividend yields. Credit losses happen, and it's important to remember that money can be lost as quickly as you can make it. For businesses like BDCs, it's all about the long haul. If you can ride the waves, you'll likely do fine. Panicking, like many did in 2009, only served to reduce returns.

Now is a great time to ask yourself if the dividend stocks you love now are stocks you'd feel comfortable holding in a credit crunch. If not, it may be smart to rethink your portfolio. 

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The article 1 Big Risk Investors Are Missing in This High-Yield Industry originally appeared on Fool.com.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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