Prospect Capital: A 12.30% Yield With 15% Upside Potential

| About: Prospect Capital (PSEC)


Prospect Capital’s stock has lagged in recent months due to increased selling pressure related to ETF selling.

However, business is good, with massive loan originations in Q1 2014, likely leading to higher NII.

Prospect Capital was recently upgraded to 'buy' at Guggenheim with a $12 price target.

With a 12% dividend yield, Prospect Capital remains a good choice for income.

Prospect Capital (NASDAQ:PSEC) has been on an absolute spending spree over the past few weeks. For Q1 2014, the company closed on over $1.3 billion loan originations, nearly doubling last year's total. In addition, Prospect Capital has been aggressively raising cash, recently completing a large convertible note offering. This will likely mean further increased loan activity for Q2 2014.

Prospect Capital raises $400 million in convertible notes

On April 8, Prospect Capital announced that it had completed its $400 million offering for Senior Notes due in 2020. The interest rate on this debt is a somewhat modest 4.75%.

After 6 years, these notes will be convertible to Prospect Capital's common stock at a rate of 80.6647 shares per $1,000 principal amount of Notes. This implies a conversion price of $12.40 per share, or about a 15% premium to recent prices.

If prices hold, these notes will very likely be converted into common stock, diluting current shareholders by 32 million shares, or around 10%. This dilution is somewhat offset from the premium to current prices.

Given the size of the offering, it seems Prospect Capital got a good deal. Having access to $400 million with a cost of capital of 4.75% may lead to some serious NII per share accretion once fully deployed.

However, we also now have somewhat of a "roof" for Prospect Capital's share price, since the company was willing to essential issue shares at $12.40. That being said, a 15% premium to current prices is still a fairly strong return, especially given the current 12% dividend yield.

Is origination demand ticking higher?

While this may be speculation on my part, it seems as if Prospect Capital is seeing an increased demand for loans. Over the past few weeks, there have clearly been more loan originations, with $556 million announced towards the closing days of Q1 2014.

In my earlier article, I noted that the company had experienced a cool down in demand during late 2013 as many BDCs competed for the same loans. This increased competition may have forced Prospect Capital to invest large sums into non-core areas such as rental properties and auto lending.

Investors should note that Prospect Capital is constantly in need to recycle capital as older loans are repaid. New investments must be made in order to keep NII inline with the dividend. The search for high returns is the main risk when investing in this stock as credit quality may suffer if the loan pipeline dries up.

Prospect Capital gets upgraded by Guggenheim

On April 10, Prospect Capital was rewarded with an upgrade to buy at Guggenheim. The firm also increased its price target for the stock to $12.00 per share. About two months ago, Wunderlich Securities upgraded the stock to a buy with a similar $12.00 price target. In December, Deutsche Bank's Stephen Laws upgrade shares of the stock to a buy with a $12.25 price target.

See the trend? While I rarely focus solely on analyst ratings, Prospect Capital clearly seems to gathering steam with the group. There seems to be consensus that Prospect Capital's fair value should be at or above $12 per share.

BDC selling may hamper upside gains for a few more months

As investors in BDCs should know, the Russell and S&P Dow Jones are removing BDCs from their respective indices. Prospect Capital has been among the least affected BDC, with the average decline at about 8.4%.

This issue should be resolved by June 2014, which is when the benchmarks are updated. Investors should expect strong selling pressure on Prospect Capital's stock. However, the Q4 2013 NAV of $10.73 should provide support.


Prospect Capital should report its Q1 2014 results sometime in the next few weeks. It will be interesting to see how NII holds up, especially given the large amounts of investments made during the quarter.

For dividend investors, Prospect Capital seems like a strong pick. Its 12% yield is among the highest in its sector and by itself provides a compelling total return. Do note that these dividends are locked in through September 2014. Furthermore, given the bullish analyst ratings, we may see some capital appreciation thrown into the mix.

Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.

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.