Top Risk-Adjusted Short-Term Returns With Prospect Capital

| About: Prospect Capital (PSEC)

I believe that Prospect Capital (NASDAQ:PSEC) offers the best risk-adjusted return for individual investors until interest rates rise high enough that corporate bonds reclaim the crown. Meanwhile, historically speaking, money from bonds and treasuries tends to flow to equities while interest rates are rising.

However with the threat of a China hard landing along with a weak global economy, the fact that the S&P 500 is near its all-time highs makes most stocks risky.

At the moment and in the near future inflation in the U.S. looks to be below 2%. (Source). So because PSEC has a current yield of about 12.27%, inflation is not a significant risk to its stock price.

The main concern is something that can increase inflation: the $1.86+ trillion that is currently parked by U.S. banks at the Federal Reserve, earning just 0.25% interest. (Source)

Once interest rates are high enough, banks will start to lend it out or invest elsewhere unless either the banks' reserve requirements are raised further or the Fed sufficiently raises the amount of interest it pays. If the Fed or policymakers fail to prevent that $1.86+ trillion floodgate from being opened, inflation will peak.

Right now if you buy a 30 year duration corporate bond with a yield to maturity of about 5.4%, and the corporation's credit quality in relation to others doesn't change, the price of the bond will have decreased by about 15 - 20% by the time the Fed reaches its target rate of about 3.5%. I base this estimate on the current price of bonds that were first sold at a time when the Fed interest rate was about 3.5% along with simple math. So if the Fed's current estimate of their schedule about raising interest rates proves to be accurate, your total return would be near 0% if you sell the bonds after a few years. Buying stock of BDCs such as PSEC shields you from this kind of a loss, but it does not shield you from recessions or disastrous events.

While Prospect Capital's income will rise once the Fed starts increasing interest rates, Prospect Capital's interest income is unlikely to rise significantly until the Fed actually increases the rates.

So while the talks of tapering and the Fed's plans about future interest rates have increased the yields of bonds and treasuries, they don't increase the interest income of most business development companies, because even though many of BDCs' fixed income investments have variable interest rates, those rates are often tied to LIBOR rates and not treasury yields. Such is the case with Fifth Street Finance (NYSE:FSC) and PSEC.

PSEC, according to their own fair value estimates provided in their latest quarterly report, has had about 28% of their current investments, judged by the number of companies, lose market value since purchase. And about 32% of them gained value. The rest (about 40%) were reported to have about the same value as before. Most of the gains and losses of their current holdings are relatively small.

Note that even many of the ones that have "lost value" might actually still be net positive investments because I did not figure in interest nor dividend income in determining whether the investment had actually lost value or not. So this confirms that their portfolio is very stable and their current investments have mostly done well so far.

I researched further some of the companies that Prospect Capital has invested in.

Let's start with the $197.3 million first-lien senior secured credit facility investment in Capstone Logistics, LLC.

The company was formed as a result of the merger between Progressive Logistics Services (PLS) and LMS Intellibound (LMS).

Capstone Logistics is a leading company in its industry. Operating all over the U.S with over 240 logistics centers.

In the very unlikely event that the company with history dating back to 1986 goes bankrupt, PSEC would likely be able to recover their investment due to the amount of assets Capstone Logistics has and their clear liquidation value.

- The loan to Capstone Logistics is due 9/16/2016. The loan has a variable interest rate. (Currently around 9%).

Moving on to the $100 million senior secured loan investment in the recapitalization of Broder Bros., Co. leading wholesale distributor of imprintable sportswear and accessories in the United States.

This company's history dates back to 1919. Grown both organically and through acquisitions. This company had a net loss every year from 2004 to the beginning of 2009, with a equity deficit of $126.875 million at the end of 2008. (Source)

This led the company to default on its debt and restructure it in 2009. Senior unsecured bond holders lost over 55% of their investment's principal value.

For the nine months ended September 29, 2012, which is their last publicly reported quarterly results that I could find, they had net sales of $610.3 million. Down 1.8 % compared to the first nine months in 2011. Net income for the nine months ended September 29, 2012 was $6.7 million. Down 76.6 % compared to the first nine months in 2011. On September 29, 2012 they still had an equity deficit of $27.7 million. (Source)

From this we can conclude that $100 million is a large investment to a company of this size, which is in financial trouble. And so it is a moderately risky one. I say moderately because it is a secured investment.

That means that in case of a default, the loss of principal wouldn't be a major portion of the $100 million and definitely insignificant to PSEC.

- The loan to Broder Bros is due 6/27/2018. The loan has a variable interest rate. (Currently around 10.75%).

Moving on to Prospect Capital's biggest investment, First Tower, LLC. Of which PSEC owns 80%. It does business as Tower Loan and was originally founded in 1936 as ReliableFinance Company, Inc.

PSEC Receives a yield of about 20% for their $290 million investment.

This looks like a solid, well run, stably profitable consumer installment lending company with over 700 employees serving over 200,000 customers. The company survived the subprime mortgage crisis. The managers also own a significant portion of company stock.

As of January 31, 2013, First Tower had total assets of approximately $633 million including $402 million of finance receivables net of unearned charges. As of March 31, 2013, First Tower's total debt outstanding to parties senior to PSEC was $265 million. (Sources: Latest quarterly report of PSEC and Tower Loan's website.)

So in conclusion, the investment in First Tower looks safe for now.

The latest U.S jobs report confirms that the U.S economy is doing well in comparison to other world economies and so I rate PSEC as a buy. If the U.S was in a recession I would steer clear from any business development companies unless the dividend yield was much higher to compensate for the risk. I would rate PSEC a strong buy if the price drops below $10.40 again, and sell if it goes above $11. The net asset value of PSEC, which was $10.71 at the end of the first quarter of 2013, has effectively limited the upside after the price of PSEC has hit above $11. I expect a small book value drop for this quarter because of the rising treasury yields but PSEC's average debt duration is not long and the coupon rates of their investments are so high that book value downside risk is limited.

Disclosure: I am long PSEC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.