Exceptional Opportunity To Buy Investment Grade Baby Bond With A Yield 7.1% From Prospect Capital

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About: Prospect Captl Notes 2018-15.06.29 Lkd to Rating Changes (PBC), PSEC, Includes: OCSL, PBY, SNHNL, SNR
by: Rida Morwa
Summary

This article is about a "baby bond" Prospect Capital Corporation 6.875% Note (PBC) maturing in 2029 which now yields 7.06%.

PBC is issued by Prospect Capital, one of the largest business development companies (BDCs) which makes debt investments (loans) and equity investments in smaller sized companies.

PBC is rated BBB-, an investment grade rating, by S&P. The current yield is 7.06%. It's first callable on Dec. 15, 2021 but doesn’t mature until June 15, 2029.

PBC is a mispriced opportunity relative to other PSEC debt and relative to similar baby bonds with the same BBB- credit rating.

PBC is a great bond for income investors: "Investment Grade" and yields 7%-plus. This is indeed a gold nugget from Prospect Capital.

Co-produced with PendragonY for High Dividend Opportunities.

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Summary

At High Dividend Opportunities, we always are looking for juicy dividends trading at attractive valuations. This week, we spotted a mispriced investment grade baby bond that's currently yielding 7.06%. The bond being discussed in this article is the Prospect Capital Corporation 6.875% Note (PBC) maturing in 2029, and is issued by Prospect Capital (PSEC), one of the largest business development companies (BDCs) which makes debt investments (loans) and equity investments in smaller-sized companies. It also invests in collateralized loan obligations (CLOs). It's one of the larger BDCs, has traded on the exchange since 2004, and has issued hundreds of bonds. PBC is rated BBB-, an investment grade rating, by S&P. The current yield is 7.06%. It's first callable on Dec. 15, 2021, but doesn’t mature until June 15, 2029. In the report below, we will compare PBC with other bonds issued by PSEC and other similar "baby bonds" to highlight the mispricing and why we believe PBC is a highly opportunistic investment now.

The Opportunity

PBC has drifted lower since it hit its high of $25.30. Currently this bond trades at a sizable discount to other similar bonds of Prospect Capital. Why is it trading this cheap? It seems that there's a big stubborn seller who is liquidating his position. PBC has only been trading for a few months since this is a relatively new bond. The seller is probably one of the underwriters. They must have had some of unsold shares when the issue was initially placed, and the selling has created a great mispricing opportunity.

Below is a table from Quantumonline showing the details of PBC.

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PBY Source: Quantumoline (or QOL)

1- Mispricing compared to PBC's sister baby bond

Below are the details on Prospect Capital Corp., 6.25% Notes due 6/15/2028 (PBY), a sister baby bond issued by the same company (PSEC). PBY is first callable in December of 2021 and matures in June 2028 (just one year before PBC). Its coupon rate is 6.25%. It closed on recently at $24.12. That makes a current yield of only 6.48%.

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PBC Source: QOL

This very similar sister baby bond trades at a 0.5% yield discount to PBC. Notice that PBC is callable six months later than PBY and matures a year later. It also has a higher coupon rate of 6.875% and yields 7.06%. That's significantly higher than the very similar PBY baby bond. Both bonds are rated BBB- from S&P which is an investment grade rating.

Other Bonds Issued By Prospect Capital

PSEC has a very interesting, smart and safe way of financing itself. It has issued hundreds of bonds of relatively small size with a huge variety of maturity dates, some nearby and some not for many years. This significantly reduces refinancing risk as no large amounts of cash have to be raised at any one time. This may play a part in why S&P considers their bonds "investment grade."

Currently PSEC has three "baby bond" issues that trade on the stock exchange like PBC does. All of the other PSEC bonds trade on the regular "corporate bond exchange" and are not "baby bonds." The three exchange traded debt issues are PBY, PBB and PBC and have much greater liquidity than the other corporate bonds. Looking only at the baby bonds which have a similar position in the capital stack, PBC trades at a much higher yield.

  • PBY, with call and maturity dates very similar to PBC, trades with a yield of 6.6% which is about 49 basis points lower than PBC’s yield of 7.06%.
  • PBB (another baby bond by the same company), which has the same coupon rate as PBY but is callable at the end of this year (in 2019), has an even lower yield of 6.3%, or about 82 basis points lower.

PBC Vs. the Oaktree Notes of 2024

Most bonds/notes issued by BDCs are unrated, however we were fortunate enough to locate a rated BDC bond with the exact same BBB- S&P rating that PBB carries along with a maturity date that's quite close to that of PBC. This bond is the Oaktree Specialty Lending Corp., 6.125% Senior Notes due 4/30/2028 (OCSLL) which currently trades at approximately a 6.24% yield. This is roughly in line with PBB but the yield is significantly lower than PBC. OCSLL is issued by the business development company Oaktree Specialty Lending Corp (OCSL). A comparison of PBB to a similar bond issued by another BDC shows PBB to be reasonably priced. Since PBC is priced with so much higher a yield, that indicates it's PBC that's underpriced and not PBB being overpriced.

Source QOL and Author calculations

PBC compared to SNHNL

Another similarly rated baby bond is Senior Housing Properties Trust, 6.25% Senior Notes Due 2/1/2046 (SNHNL), which is issued by Senior Housing Properties (SNR), a healthcare property REIT. Although SNHNL has a much later maturity date, it's callable on 2/18/2021 which is about the same time as PBC. It too is rated BBB- by S&P. It currently trades at $25.71 giving it a current yield of 6.08%, 98 basis points lower than PBC. PBC yields 1% higher than SNHNL.

SNHNL Source QOL

PBC Vs. Regular PSEC Bonds

As stated above, Prospect Capital has many bonds that trade on the regular bond exchange (not baby bonds that trade on the stock exchanges). We have located several bonds with a similar maturity to PBC and only yield about 6.3% vs. 7.06% for PBC. For example, below is an uploaded image of regular Prospect Capital Bond maturing in February 2029 (CUSIP 74348YHV6).

Source

The corporate bond above just traded this week at a price of $98.82 for a yield of 6.3% compared to 7.0% for PBC. This is a significant yield difference. PBC would have to trade up to $25.80 (or higher by 6%) to be at fair value versus this PSEC corporate bond!

Why the Recent Down Move in the Price of PBC is a Golden Opportunity?

PBC closed at $25.30 on Feb. 1. Since that time the price has slowly drifted lower with a slightly bigger step down on the ex-dividend date of March 1. It seems that there's a stubborn seller that's liquidating a large position in PBC. Below is the price chart of PBC.

PBC Price Chart (Source: NYSE)

And the decline in the PBC share price certainly is not related to any common stock or company issue. As can be seen from the chart below (source E*TRADE), while PSEC has been volatile, during much of the period where PBC was slowly declining, PSEC was going up in price.

PSEC Common Stock Price Chart

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Ex-Dividend Date

PBC went ex-dividend on March 1. PBC is now below where it has traded except during the late December crash. Its yield is significantly higher than the very similar PBY baby bond and a similar corporate bond issued by PSEC. Our suggestion is to buy now before it moves back to a price more in line with PBY. Our reasoning is based on over 20 years of investing in fixed income. So whether you are a short-term trader or want to buy and hold PBC, we think the time to buy is now. With a current yield of 7.06% and an investment grade credit rating, this is a very good value. The next ex-dividend date is on June 1.

Other Comments on the Safety of PBC

The very good reasons we have for calling PBC safe are:

  1. The low refinancing risk that we previously mentioned.
  2. The fact that a BDC has never defaulted on a bond. PSEC went through 2008 financial crisis, one of the worst financial crisis in history, without any defaults.
  3. PSEC has low balance sheet leverage. The target is 0.7x to 0.8x net debt/equity.

As many of you already know, until recently BDCs were not allowed under the law to carry leverage of more than 1 to 1 (50%). Recent legislation allows BDCs to now leverage up to 2 to 1. However, PSEC's leverage is still well below 1 to 1 according to its latest SEC 10Q filing. Investors in BDC bonds should certainly monitor the balance sheets of their BDCs, but as for now, things look very good in terms of the PSEC balance sheet.

Source

Summary

PBC is a bond that can be a good addition for conservative income investors and retirees looking for yield with low price volatility and lower risk. The logic for purchasing PBC is relatively simple. It's selling at a bargain price relative to similar PSEC bonds as well as the most similar BDC bond that we could find with the same risk rating. Additionally, PBC has good safety, a maturity date that's medium term in duration (just over 10 years to maturity, but under three years to a possible call date), good liquidity, and it has sold off recently for no apparent reason. We see no reason that it trades at such a yield differential to PBY, SNHNL, OCSLL and the regular PSEC Bonds.

PBC should trade back to $25.50 soon and it could easily go as high as $26. That price would put its yield in line with the yield from PBY. That’s an easy 5%-plus short-term capital gain on top of the very attractive 7%-plus yield. Note that we are recommending PBC as an investment to be held to maturity and not as a trade. This is a lower risk bond that's recommended for conservative investors and retirees as "a buy and collect income" type of situation.

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Disclosure: I am/we are long PBC, PBY, OCSLL. 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.