Prospect Capital: 12.4% Yield, 63 Cents On The Dollar, I’m Not Buying (NASDAQ:PSEC)
The Fed is done raising rates which means 2024 offers business development companies a dynamic and perhaps more difficult macroeconomic environment to generate investment income. The current Fed funds rate at 5.25% to 5.50% is also likely to have been cut by 50 to 100 basis points by the end of 2024 to present a barrier for growth from the upward drift of yield. The CME FedWatch Tool has ruled out any further hikes with the Fed 100% set to keep rates unchanged through its next two Federal Open Market Committee meetings. We’re on the brink of the long-elusive dovish pivot and Prospect Capital’s (NASDAQ:PSEC) headwinds could be set to compound. The BDC has frozen its monthly cash dividend at $0.06 per share for a 12.4% annualized forward dividend yield.
The 6 cents per share monthly distribution has been in place since September 2017, defying the surge in dividends and supplemental witnessed across the BDC space as the Fed took interest rates to their current 22-year high. Whilst PSEC faces an economic base case for next year deemed the ‘Goldilocks scenario’ of continued strong US economic growth and elevated interest rates, the BDC’s lack of dividend growth will likely see its current 37% discount to net asset value (“NAV”) remain rigid. PSEC’s discount is reflective of historical cuts to its monthly distribution aggregated with a high non-cash payment-in-kind (“PIK”) and dilution to drive a decline in NAV per share.
Portfolio Yield, Net Asset Value, And Dilution
Non-bank lender PSEC focuses on providing credit to middle market US companies and held a portfolio valued at $7.74 billion as of the end of its fiscal 2024 first quarter ending September 30, 2023. This came with a 10.3% investment yield and, a 57.3% allocation to first lien debt with 83.4% of interest-bearing assets also at floating rates. The BDC has been migrating its portfolio towards first lien debt, this is up 550 basis points over its year-ago comp with equity investments and its allocation to the highest risk tranche of collateralized loan obligations (“CLO”) realizing declines of 130 basis points and 110 basis points respectively. CLOs are highly leveraged instruments formed by the pooling together of a diversified number of corporate loans.
PSEC is one of the oldest BDCs, going public in the summer of 2004 with total returns year-to-date at negative 14.5% which has lagged behind its peers. The BDC’s double-digit yield is attractive but this has come at the cost of NAV. PSEC has also ramped up its average diluted shares outstanding despite trading at a discount to NAV. The opposite action of issuing shares at a premium is typically accretive to investment income, but PSEC has grown its diluted shares outstanding by roughly 74% over the last five years.
NAV at $9.25 per share dipped by a substantial 76 cents from $10.01 per share in the year-ago quarter. This continued decline of NAV has driven the rigidness of the discount with the common shares, currently trading for 63 cents on the dollar, last trading at parity in 2017. To be clear, PSEC’s discount to NAV has expanded in an economic environment where the Fed’s actions have driven BDCs to generate record investment income, dividends, supplementals, and special distributions. Hence, the persistence of the discount could be described as encapsulating capital flight to its peers. PSEC has maintained a capital raising strategy that’s dilutive to earnings.
Investment Income And PIK
PSEC recorded a first-quarter total investment income of $236.2 million, which grew by 16.7% over its year-ago quarter with a net investment income of $125.6 million topping $99.3 million from its year-ago period. NII on a per share basis at $0.25 meant the BDC is currently paying out 72% of NII as a dividend every three months. Critically, PSEC’s NII dividend coverage has improved markedly with first-quarter coverage of 138% a drastic improvement from 122% coverage in the year-ago quarter and 127% in its fiscal 2023 fourth quarter. The high dividend coverage has failed to stem the NAV decline with the rapid expansion of shares, including convertible notes which have formed a significant element of PSEC’s capital stack, forming the core headwind against NAV on a per share basis.
PSEC recorded first quarter PIK income of $23.1 million, around 18.4% of NII and far above a low single-digit threshold of comfort of around 5%. This implies near-term loans on non-accrual status could rise. Hence, I’m not attracted to the double-digit yield and discount to NAV even with improving dividend coverage. Protecting NAV is the primary objective for a BDC and PSEC faces continued challenges to this in 2024 without the uplift from short-term SOFR rates ramping up its asset yields as the Fed funds rate reaches a plateau. The ticker’s dividend chart does not look good but its a hold at the current level.