E Prospect Capital: Is The 11% Dividend Yield Safe?

Business Development Companies, otherwise known as BDCs, are widely sought after by income investors because of their high dividend yields. Indeed, investors can find multiple stocks on our BDC list with high dividend yields above 5%.

One particularly striking example is Prospect Capital (PSEC), which currently has a dividend yield above 11%. Of course, any time investors see a double-digit dividend yield, they should be sure to conduct proper due diligence to make sure the company is not in danger of a dividend cut. Fortunately, we believe Prospect Capital’s dividend is secure, although a protracted recession could place the dividend in danger.

Business Overview

Business Development Companies are publicly-traded stocks that invest in the debt and equity securities of smaller, privately-held companies. BDCs operate similarly to private equity or venture capital firms. BDCs make money by earning interest and dividends on portfolio investments, as well as on capital gains when portfolio investments are sold.

Prospect Capital’s portfolio consists of 125 investments, totaling over $5 billion of assets. Approximately 43% of investments are in first-lien debt. Another 23% is invested in second-lien debt securities, while subordinated structured notes comprise 15% of investments. Equity makes up 17% of the investment portfolio. Prospect Capital typically invests in middle-market companies with annual EBITDA of $5 to $150 million.

Among its portfolio, the largest investment is National Property REIT Corp, which made up approximately 17% of the total investment portfolio as of the 2019 third quarter. First Tower Finance Company, a buyout firm, comprises 9% of assets. In all, Prospect Capital generates a total portfolio yield of slightly above 10%.

Investors should understand the various risks associated with Prospect Capital and investing in BDCs. These risks include interest rate risk and credit risk. Fortunately, Prospect Capital has a well-capitalized balance sheet and solid credit metrics. For example, the company receives an investment-grade credit rating from Standard & Poor’s and Moody’s. Approximately 72.0% of assets are unencumbered. The company has maintained a weighted average net leverage ratio below 4.7x since the beginning of 2018.

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