Prospect Capital: Surprisingly well-covered 14% dividend yield (NASDAQ:PSEC)

Prospect Capital Corporation (NASDAQ:PSEC) is a well-run business development company that has had no problems covering its dividend with net investment income over the past year.

In fact, Prospect Capital currently has a better dividend payout ratio than some of its larger, more appreciated BDC cousins.

Prospect Capital's credit profile also improved quarter-on-quarter as the non-accrual ratio fell to a low 0.3%, suggesting impressive credit quality for the business development firm.

I do not believe the large discount to net asset value is justified given Prospect Capital's strong financial position and performance. The 14% dividend yield is sustainable in my view.

My grade history

My latest stock rating for Prospect Capital was Buy as a higher-for-longer rate environment benefited Prospect Capital and the business development company had strong credit quality.

Prospect Capital's credit quality increased further in the fourth quarter of 2024 and the dividend was even better covered by net investment income than in the previous quarter.

Portfolio and income review

Prospect Capital is structured as a business development company under the Investment Company Act of 1940 and is therefore required to distribute 90% of its taxable income to shareholders.

The commercial development company holds a large lower-middle market loan portfolio and has considerable exposure to real estate investing. Real estate accounted for approximately one-fifth of Prospect Capital’s investment portfolio as of June 30, 2024, which was valued at $7.7 billion.

Prospect Capital earned $102.9 million in net investment income for the quarter ended June 30, 2024, reflecting a year-over-year decrease of 9%. The majority of this income is derived from interest income on Prospect Capital’s first- and second-lien debt, and the business development company has created a floating rate position amounting to 82.1% of assets.

What is working well for Prospect Capital right now is the performance of its portfolio. The business development firm has a very low amount of unearned assets in its portfolio, which translates into substantial excess coverage for passive income investors.

Prospect Capital's low non-accrual rates of 0.3% based on fair value help differentiate BDC from some of its peers, particularly companies such as Oaktree Specialty Loan Corporation (OCSL) which recently suffered a surge in defaults, raising concerns about the dividend.

The dividend payout ratio is really impressive

The business development firm doesn't have the best reputation in the BDC industry because Prospect Capital occasionally earned less than it should have on its dividends thanks to net investment income, which in some cases led to dividend cuts.

Furthermore, Prospect Capital's net asset value track record is not the best either, with the BDC reporting a long-term decline in its NAV.

Regardless, Prospect Capital's dividend payout and credit quality look very good right now. Prospect Capital earned $0.25 per share in net investment income in the most recent quarter, which equates to a dividend payout ratio of 72%.

Prospect Capital's dividend payout ratio over the past 12 months was even better: The BDC paid out only about 70% of its total net investment income.

Most of the BDCs I've looked at lately, including industry heavyweights like Ares Capital Corp. (ARCC) either Blue Owl Capital Corporation (OBDC) They had higher dividend payout ratios. Ares Capital Corp. paid out 85% of NII, while Blue Owl Capital paid out 73% of its net investment income.

Excessive discount on net asset value

Prospect Capital shares are selling at a 40% discount to net asset value, which seems a bit steep considering the company's non-accrual credit profile is healthy and the business development company had no trouble covering its dividend payments.

Prospect Capital's net asset value amounted to $8.74 per share as of June 30, 2024 (my estimate of implied intrinsic value), reflecting a decrease of $0.25 per share primarily due to net realized and unrealized losses.

I find a 40% discount to net asset value to be quite exaggerated given that the BDC's most important KPIs actually look quite good, and in some cases are even better than those of BDCs that have a higher perceived investment quality, such as Ares Capital Corp.

Why the investment thesis could disappoint

The central bank is set to cut short-term interest rates next month, pointing to weaker leverage for net investment income growth, particularly for those BDCs that are heavily concentrated in floating-rate BDCs.

Prospect Capital is not the best-positioned floating-rate BDC, but the company has considerable exposure to high interest rates.

As far as the dividend is concerned, however, I don't see any major issues, but I would like to state that monitoring Prospect Capital's dividend payout ratio is a must.

My conclusion

Like it or not, Prospect Capital looks pretty solid as a BDC investment right now and I think the business development firm's 14% yield is relatively safe.

It is the large 40% discount to net asset value, coupled with the 70% LTM dividend payout ratio and low amount of non-performing loans that makes Prospect Capital's 14% yield surprisingly competitive.

Prospect Capital's credit quality and dividend payout ratio look attractive and I don't see any major issues in the portfolio or BDC's earnings trend that would indicate to me that the dividend is destined to be eliminated.

With net asset value at such a high discount to book value, I believe Prospect Capital remains an exceptionally attractive investment option for passive income investors and I believe PSEC should be able to trade at a much smaller discount to book value going forward.