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Two week ago, I urged investors to consider buying shares of Annaly Capital (NLY) to profit from a near term pullback in rates (you can see that article here). Since then, the 10 year yield has drifted a little lower, sending NLY up 6%, and major investors including Jeff Gundlach have recommending purchasing its shares. I continue to believe that rates will drift lower or stay flat through the end of the year, so I see NLY performing very well in the next 3-6 months, trading back towards $13.

However in my estimation, this pullback in rates comes in the broader context of a prolonged rate rally from their historically low levels. At some point in 2014, the Fed will stop easing, and in 2015, they will start to swiftly hike the Fed funds rate. In this environment, interest rates will rise. I am currently targeting 2.75% at the end of this year, 3.25%-3.50% at the end of 2014, and 3.75%-4.25% in 2015. So while in the immediate term I am bullish on NLY, I think for investors with a longer-term horizon of 3-5 years there are better plays to generate income. Today, I wish to present another "bond-replacing" stock that will generate increased returns as rates rise.

As the Fed moved interest rates to zero, investors received virtually no yield on their bond holdings. With many long-term investors holding a large bond position of 30-50% in their diversified portfolio, they began to look for bond-replacing stocks that provided a more reasonable yield while having less risk than a normal equity. Mortgage REITs were an extremely popular choice as they tend to yield well over 5% while having a levered position in mortgage back securities. Going forward, I think investors will be better served holding business development companies (BDC) than mortgage REITs as a bond-replacement in their portfolio. Specifically, I am very optimistic about the future of Prospect Capital (PSEC).

For those who don't know, a BDC passes through its income to shareholders and must return 90% via distributions, similar to the structure of a REIT. These firms are mid-market lenders who under tax law have to focus their lending on firms with less than $250 million in sales. Among BDCs, PSEC is an exceptional performer. It has not initiated a non-accruing loan in six years and did not have to cut its dividend in the depths of the recession while competitors were hampered by bankruptcies of their holdings. In its 25 year history (10 as a public company), it has a history of originating low risk loans and increasing current income.

At Friday's close of $11.07, the shares offer a 12% yield on its monthly $0.11 dividend, but they do trade at mild premium to book value of $10.72. However in the past, the stock has traded more than 50% above book value, and a growing distribution of 12% is nothing to sneeze at. PSEC mostly lends at the top of the credit structure through senior and secured loans, which provides good visibility for future cash flows. In fact, it has already declared its next six monthly distributions, each one marginally larger than the previous. Compared to the mReits like NLY who have been forced to cut payouts, this is a superior model. Moreover, the firm often takes an equity position to provide cushion to its secured debt position (similar to how Warren Buffett required warrants in addition to his preferred share loans to Goldman Sachs (GS), General Electric (GE), and Bank of America (BAC)). These positions can provide a capital gain boost to net asset value.

At the end of its last quarter, PSEC had an investment portfolio of $4.2 billion. 53% was in senior debt, 27% in subordinated debt, 16% in CLOs, and 4% in equities. Some investors have grown wary about its CLO holdings, but I disagree. Compared to just about every other pooled securitized product, senior CLOs performed extremely well during the crisis. With diversified companies within the product and equity and subordinated holders risking the first 30% of capital, a CLO investor will do extremely well. Given PSEC's strong risk management, I am very comfortable with its investment breakdown. By investing mostly high in the capital structure, PSEC has strong cash flow visibility and an underwriting team that has rarely made an overly risk investment. With its 12% yield, PSEC is clearly a strong investment, and with its holdings of debt securities, it is a logical bond-replacement stock. I now want to make the case that PSEC is better than NLY and mREITs in general.

There is one critical difference in their business: PSEC benefits as rates rise while NLY benefits from a decline in rates. 89% of PSEC's holdings are floating rate instruments. Borrowers must pay a certain amount above LIBOR, so as rates rise, the amount they pay in interest goes up. At the same time, 93% of PSEC's debt outstanding pays a fixed rate. In other words, in a rising rate environment, interest income will rise substantially while interest expense stays roughly flat, increasing net income and distributions. For PSEC, once LIBOR hits 2%, likely around the end of next year, it will earn an additional $19 million ($0.08) for every 1% rise in LIBOR. By the end of 2015, I believe the increase in rates will increase PSEC's distribution by 10% on top of planned increases from its growing business. Over the next three years, PSEC could grow distributions at an annualized 5-10% depending on the speed of the rate rise, not bad on top of its current 12% yield.

Conversely, 91% of NLY's assets are fixed-rate while it borrows on the short-term market at a floating rate. As such, as rates rise its interest rate spread declines, which has led to several dividend cuts. Its interest rate spread has fallen below 1% as rates have begun to tick up. With its leverage ratio of 6.2x, the company is very sensitive to rates. For comparison, PSEC is only levered at 1.6x, yet it can provide basically the same dividend payout.

It is important to recognize that NLY does not take credit risk as it purchases bonds backed by Freddie and Fannie, but its securities have one very unenviable future. As interest rates rise, these bonds are worth less because their low interest payment is less attractive; however, their duration extends. You see, as rates rise, borrowers are less likely to refinance their mortgage or prepay principal because the rate they borrowed is more attractive. With the underlying mortgages lasting longer, the bonds pay out later, lengthening their duration. In a sense, the less attractive these securities become, the longer NLY is stuck holding them, extending their low income generation problem. Conversely, as rates rise, floating-rate debt has a shorter duration, which will allow PSEC to originate new loans with a higher LIBOR floor, guaranteeing more income should rates fall again while collecting some prepayment penalties.

Conclusion:

The longer term investor who is looking for generating increased income from bond-replacing stocks needs to carefully understand the impact of higher interest rates. Mortgage REITs like Annaly Capital will face tightened interest rate spreads and longer duration assets, leading to dividends that are cut even further. I think NLY could cut its dividend down towards $0.25 in 2014. Instead, investors should look to BDCs, in particular, Prospect Capital, which lend at a floating rate and borrows at a fixed rate. PSEC is levered to a rise in interest rates while maintaining strong underwriting practices with relatively low leverage of 1.6x compared to NLY's 6.2x. PSEC will keep growing its 12% payout, making it a perfect play for income investors and dividend growth investors alike. While NLY and other mREITS should perform well through the end of the year, I would use that strength to sell and rotate into PSEC, which has far superior long-term prospects.

Source: Prospect Capital Benefits From Rising Rates