Updated on December 15th, 2022 by Josh Arnold
Business Development Companies — or BDCs, for short — allow investors to generate income with the potential for robust total returns while minimizing the tax paid at the corporate level.
Despite these advantages, business development companies are generally avoided by investors. This may be due to the tax implications of their distributions for their shareholders. But even with the added headache come tax time, BDCs can still be worthwhile for income investors.
Prospect Capital Corporation (PSEC) is one of the more attractive business development companies in the market today.
Prospect stands out from the crowd in that it pays monthly dividends, giving its shareholders a steady and predictable passive income stream, which is highly appealing to income investors.
There are currently just 49 monthly dividend stocks. You can download our full Excel spreadsheet of all monthly dividend stocks (along with metrics that matter, like dividend yield and payout ratio) by clicking on the link below:
Prospect Capital has a tremendously high dividend yield of 9.9%, more than six times that of the average S&P 500 stock. You can see our full list of stocks with 5%+ dividend yields here.
Prospect’s high dividend yield and monthly dividend payments are two of the reasons why the company merits further research. This article will discuss the investment prospects of Prospect Capital Corporation in detail.
Business Overview
Prospect Capital Corporation is a Business Development Company that was founded in 2004. Prospect Capital is one of the largest business development companies with a market cap of almost $3 billion.
Details about Prospect Capital’s business model can be seen below.
Source: Investor Presentation
Prospect Capital is a leading provider of private equity and private debt financing for middle-market companies, broadly defined as a company with between 100 and 2,000 employees.
Operating in the middle market benefits Prospect Capital because of the lack of competition from larger, more established lenders.
Middle-market companies are generally too small to be the customers of commercial banks but too large to be served by the small business representatives of retail banks. The “sweet spot” between these two services is where Prospect Capital does business. This lack of competition in this sector has allowed Prospect Capital to finance some truly attractive deals.
The company’s current portfolio yield is 9.9%, which is up sharply from recent quarters, where the company’s yield dipped below 9%. Rising interest rates around the developed world have increased the company’s floating rate portfolio positions yield.
Investors should note that Prospect Capital is highly exposed to volatile interest rates. This is because the company’s liabilities are nearly all at fixed rates, while its investments are nearly all floating-rate instruments. That means interest expense is largely fixed, while interest income rises and falls commensurately with prevailing interest rates.
As interest rates rise, the revenues from Prospects floating-rate interest-bearing assets will increase. At the same time, Prospect’s interest expense will remain constant since most of its debt is fixed. Of course, the opposite is true, as falling rates generally mean declining interest income.
This makes Prospect Capital a great portfolio hedge against interest-sensitive securities like REITs and utilities, but it underperforms when rates are very low and when rates are declining.
Prospect Capital’s flexible origination mix is also a meaningful positive from an investor’s perspective, given that the wide variety of instruments it uses to produce income helps it find the best opportunities.
The company has nine different ways to invest with target companies, including different types of debt and equity. They all have different risk levels and rates of return.
Prospect Capital’s willingness to seek out the best instruments — and having the scale to do so — is a major advantage over other middle-market BDCs. The company’s investment strategy is central to its long-term growth.
Growth Prospects
Prospect Capital’s growth prospects stem largely from the company’s ability to:
- Raise new capital via debt or equity offerings
- Invest this new capital in deal originations with an internal rate of return higher than the cost of capital raised in Step 1
Prospect’s ability to source new deals that offer appropriate risk-adjusted returns is the most important part of this process.
Fortunately for the company (and its investors), there is no shortage of new deals for Prospect’s consideration. The company has thousands of deal opportunities each year, allowing it to be very selective in its investment decision-making.
Prospect reported first-quarter earnings on November 9th, 2022, and the results were strong. Net investment income per share was 22 cents, which was four cents better than expected. Total investment income was up nearly 20% year-over-year at $203 million. In addition, that number beat estimates by $16 million. Net asset value ended the quarter at $10.01 per share, and while that was down against the prior quarter, it’s a significant premium to the current share price, under $8.
Prospect ended the quarter at $7.6 billion in investments, and the portfolio’s current yield is 9.9%. We think the company can earn 93 cents per share this year.
The company focuses on disciplined underwriting to avoid undue risk when making new deals. In addition, it is willing to pass when that is the prudent course of action and exit when the time is right.
Source: Investor Presentation
Dividend Analysis
Prospect Capital’s dividend is the obvious reason investors would choose to own the stock, so it is critical that the dividend is as safe as possible. As a BDC, Prospect Capital has no choice but to distribute essentially all of its taxable income to shareholders. Because of this, its payout ratio will always be very high and sometimes variable.
Prospect Capital produced $0.22 per share in net investment income for the most recent quarter, which sufficiently covered its quarterly distribution of $0.18 per share.
In other words, the dividend is actually covered by net investment income and has been for some time, meaning the payout should be relatively safe, barring a sizable impact from any potential economic downturn.
The company has declared $19.86 in cumulative distributions to shareholders since 2004. That’s almost three times the current share price.
Source: Investor Presentation
Clearly, the draw for Prospect Capital is in its ability to generate cash to return to shareholders, and over time, it has done that well.
The dividend appears safe for now, but investors should continuously monitor the company’s net investment income for any signs of trouble that could potentially lead to further cuts down the road. We don’t see that as a threat at the moment, as the company has consistently covered its payout in the past several quarters.
Related: 3 Reasons Why Companies Cut Their Dividends (With Examples)
Final Thoughts
Prospect Capital’s high 9.9% dividend yield and its monthly distributions are two of the main reasons why an investor might take an interest in this stock.
Taking a closer look reveals that this BDC has a high-caliber leadership team and has positioned itself to thrive in most environments.
The dividend appears sustainable for the time being, meaning Prospect is worth a look for those investors seeking high levels of current income and monthly payments, plus stomach the inherent risks of owning a BDC.
If you are interested in finding more high-quality dividend growth stocks suitable for long-term investment, the following Sure Dividend databases will be useful:
The major domestic stock market indices are another solid resource for finding investment ideas. Sure Dividend compiles the following stock market databases and updates them monthly:
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