Prospect Capital Corporation (NASDAQ:PSEC) is a BDC that leaves investors polarized. Some despise the name for their massive management fees and relatively weak buybacks, but others love the enormous yield, attractive P/E ratio, and ability to enter their position at a huge discount to book value. Despite the disagreement among shareholders and other potential investors, there are some opportunities that should be very interesting to investors.
No Arbitrage Pricing
There is a central theme in markets that pricing should always include "no arbitrage" opportunities. Since a well-designed computer system can sniff out arbitrage opportunities and capitalize on them, it should be no surprise that these opportunities won't prevent themselves. However, there are opportunities that come extremely close to violating the no arbitrage rule. The reason these opportunities can exist is because uncertainty over future dividend payments removes the ability of a robot to rapidly sniff out and capitalize on some opportunities.
An Article Caught My Eye
I saw an article by Richard Lejeune that caught my eye. I don't usually spend much time on the options market. I explored it previously seeking precisely the kind of arbitrage opportunities that a great system is designed to sniff out. I determined that even though the market can make some absurd pricing mistakes (remember PSEC selling around $5.26 a share?), the options market usually wouldn't offer much in the way of opportunities.
This time there is a mistake in the market prices. This wouldn't normally occur because computers can spot the failure, but remember that neither investors nor computers know precisely what will happen with dividends. That makes companies with huge dividend yields a very interesting area for the option market.
The dividend for Prospect Capital is running $.08333 per share per month. Shares regularly go ex-dividend very close to the end of the month. That means investors should expect 8 dividends prior to the January 2017 strike date.
The Focus of This Article
It might seem like this is focused on using options, but the options are only a tool in the analysis. The goal here is to provide a substantially better investment opportunity that reduces the risk of damage due to a dividend cut.
I simply ask that investors follow along as the process will be surprisingly quick.
The following option chain was represented over the weekend when I was pulling the data:
I added the green and red boxes to highlight the options I wanted to discuss as tools for investing in PSEC.
I tossed in a quick "no arbitrage" model which should indicate that the return on buying PSEC, and the put option combined with selling the call, receiving dividends, and selling PSEC through the option use in January (effectively locking in $7.50 as the price) would be about equal to the risk free rate.
The no arbitrage model using the middle of the bid-ask spreads suggests that the investor here is pretty much locking in a loss. They lock up their capital for 8 months and are rewarded with a significant loss. This usually would be a much smaller loss or gain. A large loss usually indicates an illiquid option market. For instance, the middle of the bid-ask spread on the $5 call is absurd. The bid is $.75 relative to the ask of $2.45.
Since the bid-ask spread is not particularly large on the $7.50 strikes for either the put or the call, I quickly reorganized the models to establish the effective cost of buying shares by selling the put and buying the call. I'm demonstrating the model with two sets of assumptions. One is that the investor is able to execute in the middle of the spread on both sides. The other suggests that the investor is stuck crossing the bid-ask spread on both options.
If the investor was able to execute at the middle of the spread on both options, they would effectively save $.46. If they had to cross the spread both ways they would still save $.31.
For some investors, that chart might still seem awkward to read, so I put together one that will be much more intuitive:
Why Can't Investors Short for Very Near Arbitrage
These are American options so they could be used before the expiration date, but that doesn't seem like a dramatic risk because the investor is selling the put and buying the call. It would be very interesting if the other side of the party wanted to utilize their put early and force the investor to accept extra dividends. That isn't the kind of risk that would keep me up at night.
It would appear like a perfect short opportunity for arbitrage trading, but it isn't quite that simple. The dividend amount isn't known. Investors would be confident that they would own shares of PSEC at expiration, but they don't know the dividend leading up to that point. If Prospect Capital substantially raised the dividend to the tune of about $.04 per share per month (almost a 50% increase) it would create a one cent loss for the investor that crossed the spread. I don't consider that a strong possibility.
Options For Investors
Some investors may opt to complete the trade and include a short on PSEC to offset the shares they would acquire on January 20th, 2017. For the simple buy and hold investor, this is a simple opportunity to buy PSEC with a better yield by saving $.31 to $.46. I see this as an intelligent way to grab a stronger dividend yield.
Wouldn't you rather own the position at a net cost of $6.2 to $6.35 in January rather than $6.66?
This is an exceptionally rare opportunity and is unlikely to be presented unless the dividends are huge and the share price or put option price is reflecting a substantial amount of emotion. In this case investors are rushing to get back into PSEC and driving up share prices while demonstrating their fear by bidding up the put options. When investors are willing to take on substantial risk in search of returns, it seems absurd to leave these returns on the counter.
Beware the trading fees and partial execution. This opportunity may get thoroughly smashed by pair traders very quickly. Investors should avoid entering this kind of trade with single leg orders. The orders should be structured as dual leg or triple leg.
Finally, I want to emphasize that investors are expected to do their own due diligence and should not mistake the opinion of an analyst as a recommendation to buy, sell, or short any security.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.