Hundreds of Seeking Alpha articles have been written about Prospect Capital (NASDAQ:PSEC), but very few have looked at it from the perspective of a debt holder. Although PSEC has been a very controversial issue for income investors, there should be little doubt about the safety of PSEC's investment grade debt. All BDCs are legally prohibited from having excessive balance sheet leverage. Controversial management fees are not a major concern for debt holders. The BDC sector has an outstanding track record of debt safety. Prospect Capital debt is less risky than most BDC peers due to the company's large size, diversification and focus on secured debt holdings.
The December 2015 IPO of PBB made it easier for retail investors to trade Prospect Capital debt. PBB is an exchange traded debt issue that trades on the NYSE. This eliminates the typical hassles of bond market trading. PBB is a par $25 issue maturing on 6/15/2024. It has a 6.25% coupon and interest is paid quarterly. At a recent price of $19.16, PBB is trading at a 10.7% yield to maturity (calculated from my Excel model). See prospectus for additional details.
PBB is equal in seniority to other PSEC unsecured debt issues with a BBB- investment grade S&P rating. This is confirmed on page S-45 of the prospectus:
"...be our general unsecured obligations, ranking equally with all of our other unsecured indebtedness (including, but not limited to, the 2015 Notes, the 2016 Notes, the 2017 Notes, the 2018 Notes, 2019 Notes, the 5.00% 2019 Notes, the 2020 Notes, the 2023 Notes and the Prospect Capital InterNotes®) and senior in right of payment to any of our subordinated indebtedness, effectively subordinated in right of payment to our existing and future secured indebtedness and structurally subordinated to all existing and future debt of our subsidiaries."
Surprisingly, PBB is now trading at a huge discount to other PSEC unsecured debt issues of equal seniority. For example, the Prospect Capital 5.875% unsecured notes (CUSIP 74348TAJ1) maturing on 3/15/2023 last traded at $92.72 with a 7.2% yield to maturity. The 3.5% yield gap between PBB and the 2023 notes is astonishing. These two issues have similar maturities and are equal in seniority.
Why is PBB trading at a much higher yield to maturity than other unsecured PSEC debt issues? PBB has been trading for less than two months and is PSEC's only exchange traded debt issue. Many investors are unfamiliar with it. Anyone who owns a lower yielding unsecured PSEC debt issue (including those listed above from the PBB prospectus) should immediately sell and buy PBB. PBB provides a significantly higher yield with equal credit risk.
The BDC sector has an outstanding track record for debt holders. As of 9/30/2015 PSEC had net assets of $3,614 billion and total liabilities of $2.956 billion. The ratio of (total liabilities/net assets) is therefore 82%. BDCs are prohibited by law from having balance sheet leverage exceeding 1X. To put that number in perspective, a typical bank has balance sheet leverage of about 10X. This may explain why the BDC sector (created to increase access to capital for small and medium sized businesses) fared far better than the banking sector during the financial crisis.
How does the credit risk of PSEC compare to other BDC issues? PSEC is among the largest and most diversified of all BDCs. 72% of PSEC assets are comprised of first lien and second lien loans. PSEC has less credit risk than smaller and less diversified BDCs with a greater focus on equity holdings. While I do not expect PSEC to sell shares below net asset value, they are permitted to do so as per their 1/8/2016 SEC filing. This additional liquidity backstop is always comforting to debt holders.
My newsletter (see additional disclosure below this article) is focused on high-yield preferred stocks and exchange traded debt issues. It's very unusual to find a double-digit debt yield from a high quality issue like PBB. PBB is clearly mispriced relative to other PSEC unsecured debt issues. This bargain is unlikely to last for long.
Disclosure: I am/we are long PSEC, PBB.
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.
Additional disclosure: Panick Value Research Report subscribers received an advance look at this article. The Panick Report is now #1 in the "Dividends" section of the Seeking Alpha Marketplace.