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Reports are rampant that there is a significant chance that the Federal Reserve decides to taper its bond purchases at its December meeting next week. If not then, Fed officials do seem antsy to take some action in Q1 2014. When the Fed surprised markets by deciding not to taper in September, the FOMC blamed uncertainty around the fiscal situation with an impending government shutdown and debt ceiling fight. After the Ryan-Murray compromise, a fiscal shock is unlikely in 2014, eliminating the Fed's excuse to not taper. With tapering starting to look likely, investors are trying to find a way to hedge against higher interest rates. I believe Prospect Capital (PSEC), a business development company, is a great way to do so.

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 and investing 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 the past six years while others were hamstrung by loans to companies that went bankrupt. In its 25-year history (10 as a public company), it has a history of originating low risk loans and increasing current income. The company's shares have traded flat this year:

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Shares have traded flat this year and are at a slight premium to book value of $10.72 as of last quarter (quarterly report here). As PSEC distributes all of its income instead of retaining it, the share price will remain relatively stagnant over time, unless it starts to trade at a big premium to book value. Prior to the financial crisis, PSEC routinely traded at a 50% premium to book, but investors don't need share appreciation to do well in the stock. Prospect pays a monthly dividend of slightly more than $0.11, which provides an 11.9% yield.

By distributing its income to shareholders, returns are rooted in the dividend rather than the share price. With book value extremely stable, investors can expect annual returns of roughly 12% based on the current dividend, which grows incrementally (a few hundredths of a penny) every month. An expected return of 12% is pretty good in this market, especially as PSEC makes high quality loans to the top of the credit structure where there is minimal risk. Prospect is also far less leveraged than banks and mREITs with a debt to equity ratio of only 53%, making a liquidity or solvency event extremely unlikely in the next 3-5 years.

At the end of its last quarter, PSEC had an investment portfolio of $4.55 billion. 76% is secured debt. Now, about 18% of Prospect's portfolio are senior collateralized loan obligations (CLOs), which some point to as a sign of risk. In reality though compared to just about every other pooled securitized product, senior CLOs performed extremely well during the financial crisis. Prospect's CLO exposure typically has 30% subordination, meaning the pool needs to lose 30% of its value before PSEC loses a penny. Given PSEC's strong history and amazing credit quality track record, I am very comfortable with its investment breakdown and CLO exposure. By investing mostly high in the capital structure, PSEC has strong cash flow visibility and an underwriting team that has rarely made a damaging investment. With its nearly 12% yield, PSEC is a strong investment.

By now, you can see why I am bullish on Prospect, but you might not see why I expect it to perform better as the Fed tightens policy. I would like to explain this now. In the debt market, Prospect borrows mainly at a fixed interest rate (approximately 93% of its debt is fixed rate), but it lends at a floating rate (typically benchmarked to LIBOR). As a consequence, as rates go up, interest income goes up while interest expense stays the same, making net interest income higher. With higher net interest income, PSEC can pay a higher distribution to shareholders. Prospect has built its business to benefit as rates rise.

Now, the benefits will not be immediate because most of PSEC's floating rate loans have LIBOR floors. About 90% of PSEC's holdings are floating rate instruments, and most have LIBOR floors of 2%. In other words if you lend at LIBOR+3% with a 2% floor, the interest rate never falls below 5% even when LIBOR hit 0.25%. As a consequence, PSEC's interest income won't go up the moment the Fed tapers. It will be a gradual process that will last over 3-4 years as rates return to normal levels. Rising rates will make Prospect's existing portfolio far more profitable with a 1% increase in rates boosting the annual distribution by $0.08-$0.10.

Moreover, Prospect is continuing to grow its investment portfolio. As rates rise, new loans will provide more income than existing ones that are being paid down. As its 2009-2011 loans become a smaller part of the portfolio, the weighted average interest rate will increase, which will also benefit the distribution. As a consequence, Prospect finds itself in a great cycle where rising interests rates will power 6-9% annual distribution growth over the next five years. Considering PSEC currently yields a robust 11.9% that is fantastic distribution growth.

Investors are looking everywhere to find ways to protect themselves from the taper with long-term bonds facing losses and concerns over the sustainability of the stock market rally without Fed support. Prospect Capital is one of the companies that is in the sweet spot for investors who want fixed-income like stability without losses from rising rates. PSEC provides fantastic current income of 12%, which by itself outpaces long-run returns for stocks. However, the firm has positioned its high quality loan portfolio to be mainly floating rate while liabilities are fixed rate. As a consequence, income and the distribution will increase as rates rise. Fed tapering and a return to monetary normalcy is great for PSEC.

Source: Profit From The Taper: Buy Prospect Capital