We all know that fixed-income yields are low in today's markets, especially short-term rates. A quick scan of investment-grade bonds with a maturity of less than two years shows yields-to-maturity (YTM) between 1% and 2%, and in most cases below 1.5%. Looking at investment grade bonds that mature around May 2015 (we will get to the reason behind this date shortly) would net an investor about a 0.8%-1.3% YTM. If you invest in an ETF like iShares iBoxx Investment Grade Corporate Bond (NYSEARCA:LQD), you can earn a YTM of about 3.3%, but you have to accept a weighted average maturity of 11.6 years (and a 7.6-year duration), which exposes an investor to a high level of interest rate risk. This combination of yield and duration is not particularly attractive.
A certain bond issued by Prospect Capital Corporation (NASDAQ:PSEC), and investment grade issuer (BBB by S&P, not rated by Moody's) offers a more interesting alternative, allowing an investor to earn about a 3.7% yield with an expectation that the bond will be called on May 15, 2014 (about 14 months away). Before getting into the specifics of this bond, I want to offer a quick overview on PSEC.
PSEC is a business development company (BDC) that primarily makes loans to middle market companies. It is one of the larger and more active lenders in this space, and the company has a highly successful track record. More information on BDCs and PSEC can be found elsewhere, but, importantly, PSEC has good scale with a $5.25 billion enterprise value and $3.5 billion market cap, and stellar results with its loan portfolio. According to management, since 2008 not a single one of its loans has failed to pay interest or principal on time, and during the worst of 2008-09, the non-accrual rate peaked at close to 6%. BDC rules require asset coverage of debt of not less than 200%, which is an attractive feature for debtholders. What this means is that PSEC's portfolio would have to undergo staggering losses of more than 50% of value before loans to PSEC itself would begin to be impaired. As of Dec. 31, 2013, total assets at PSEC were $5.2 billion vs. about $2.0 billion of liabilities -- implying even higher 2.6x asset coverage. Remember that in the worst crisis the non-accrual rate was only 6%, light years away from 50%. It is for this reason that PSEC is considered investment grade.
Now to the bonds in question. PSEC has numerous bonds issues available for purchase, with maturity dates ranging from 2018 (with an approximate 3.9% YTM) to 2043 (with an approximate 6.4% YTM). Less known are the so called "baby bonds" issued by the company that are bought and sold like a stock under the symbol PRY (also under CUSIP 74348T201). These bonds were issued in May 2012, a $100 million offering at a 6.95% coupon maturing on Nov. 15, 2022. The bonds were issued in $25 increments and pay interest in a manner similar to a stock dividend, on a quarterly basis. Unlike a typical bond, they are not bought and sold with accrued interest, so a buyer should be aware of the timing of the purchase vs. the timing of the dividend. The next ex-div. date is May 1, so not really a factor in the price as of the writing of this article.
Importantly, PRY is callable at par on May 15, 2015. Herein lies the opportunity to earn a 14-month investment grade yield of about 3.7%. It is a virtual certainty that PSEC will call these bonds on the first possible call date, as the company will not be willing to continue to pay 6.95% interest, when prevailing rates for PSEC's bonds that mature in the 2022-23 time frame are yielding in the mid-5% range (and most likely even less than that 14 months from now). In fact, PSEC's 30-year bonds are yielding only 6.4%, more than 50 basis points lower than 6.95%. Even if prevailing interest rates increase significantly in the next year, the bonds will still almost certainly be called.
It is the call date that is keeping the price of PRY limited, with the most recent price at $25.93 per share. Assuming a purchase at $26 today, which is like buying a bond at 103.7% of par, the yield to the May 15, 2015, call date is about 3.7%. What happens in the very highly unlikely scenario that PRY bonds are not called? The YTM through the stated maturity about 8.5 years from now would increase to about 6.4%, which is equivalent to the 30-year YTM for PSEC bonds and very attractive for an investment grade name.
Investors should be glad to hold these investment grade bonds beyond the call date, as the yield will only keep going up from 3.5% (up to a maximum of 6.4%) as long as they are not called. If there was no call date or the call date were later than 2015, PRY would surely trade higher than $25.93. The downside on the price of PRY also seems limited given the 6.95% coupon -- it is highly unlikely that the price will go below $25/share, even if rates rise more sharply than expected in the next few years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I personally have a position in PRY and in client accounts.
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