Better way to invest in Prospect Capital

In our last article, we mentioned the risks involved in investing in Prospect Capital (PSEC). We also shared that the return over the last 8 years for Prospect has been 39%. However, some investors (especially the ones that have made a good return over the last year) did not agree with our risk assessment and still believed that Prospect was a good investment. If investors still want to invest in Prospect, I suggest they look at Prospect’s bonds.

Prospect has issued many different types of bonds. Some of the bonds are convertible. Convertible bonds pay a fixed interest, but can be converted into shares of Prospect at a certain price. This allows investors to participate in the stock appreciation. Most of, if not all, of the bonds issued are callable by Prospect. This means that Prospect can call the bonds after a certain date before they actually mature.

We are going to focus on one bond issue from Prospect. The main reason is that most individual investors are not familiar investing in bonds. The second reason is that a lot of the issues from Prospect are illiquid.

The issue that we are going to focus on is the 6.95% Senior Notes due 11/15/2022. The neat thing about these bonds is that they trade like a stock on the NYSE. The principal on the bond is $25 and it pays a quarterly coupon ($.434375). They are callable in 5/15/2015 at $25 by Prospect. Currently, they trade around $25 under the symbol PRYIt is worth a look for investors that want to participate in the strong yield offered by Prospect, but want to take more of the risk out of the investment.

Please note that this issue is getting riskier because prospect is loading up on debt to fund their growth. We personally do not recommend any security offered by Prospect.

Read the prospectus here.

Disclosure: I do not own shares of PRY and do not plan to initiate a position within the next week.

Be Wary Of Prospect Capital

With interest rates being next to nothing at banks, investors are hurting to find safe places where they could park their cash, and still earn decent interest. One company that has attracted a lot of interest due its 10.50% dividend yield is Prospect Capital (PSEC).

Company Background

Prospect Capital is a business development company that “primarily lends to and invests in middle market privately-held companies”. They “invest primarily in senior and subordinated debt and equity of companies in need of capital for acquisitions, divestitures, growth, development and recapitalization”. As a Registered Investment Company (“RIC”), it has to distribute 90% of their taxable income to their stock holders. It currently distributes this as a monthly dividend. Since their IPO in July 2004 at $15/share, it has paid out over $10 in dividends. So what’s not to like?

Management Incentive

Prospect is managed by Prospect Capital Management. They earn 2% of gross assets and an incentive fee based on the performance of the investment portfolio. Gross assets means their total assets. It is different from net assets which subtracts the liabilities. This incentivizes the management to:

  • Increase total assets regardless of whether it is in the best interest of the share holders in order to get a higher base management fee. Assets have grown every year since inception, and so has the management fee from $1.8 million in 2005 to more  than $46 million in fiscal year 2012.
  • Make speculative investments in order to earn a higher incentive fee.
Leverage

One way to grow the total assets and earn a higher fee is to use leverage. Prospect has been raising more and more capital by selling debt. Their debt/equity ratio has increased from 21.2% in 2008 to around 43.9%. This increases the total assets, and puts more money in management’s pocket. It also creates a better return for share holders when things are going well. However, when they are not, the losses are magnified. It is the same as an individual investors buying a stock on margin. It’s great when the stock goes up, but disastrous when it goes down. Prospect indicated that they will continue to increase their leverage. “We are targeting continued growth in NII per share as we utilize prudent leverage to finance our growth through new originations, given our debt to equity ratio stood at less than 44% (and less than 36% after subtraction of cash and equivalents) as of June 30, 2012”.

Illiquid portfolio

Since Prospect invests in middle market private companies, there is no market to sell their investments. This creates multiple problems:

  • There is no way to value impairments to the portfolio and fair value is determined by the “good faith” of the board of the directors. This is a huge conflict of interest!
  • If a disastrous financial event occurs, then they will not be able to sell their investments at a fair price due to their illiquidity. This disastrous event is more probable due to the fact they are levering up the company. For example, when their debt is expiring, and the company is not doing well, they will have to either sell shares or raise debt at a discount rate.
Prospect’s Performance

All the aforementioned risks are all good points, but the company has returned $10 in dividends since inception on an initial $15 investment. However, at the end of June 2012, the net asset value of the company stood at $10.83. So, an investor’s $15 initial investment is worth $20.83 ($10 in dividend + $10.83 in n.a.v). That is an anemic return of almost 39% over 8 years. That return is definitely not worth the risk!

If investors are still not convinced and wants to invest in Prospect Capital, wait for our next article.

Read Prospect’s latest 10-K.

Disclosure: I do not own shares of PSEC and do not plan to initiate a position within the next week.

 

Safe 7.7% Yield From AIG

In our last article, we wrote about how AIG shares are significantly undervalued, and the company has shored up its balance sheet by getting rid of risky assets in its portfolio. Buying shares is one way to way to play this lack of love AIG has been feeling from the street. Another way to play it is buying the $25 denominated 7.70% Series A-5 Junior Subordinated Debentures, AVF.

AIG $25 denominated 7.70% Junior Debentures (AVF: NYSE) ($25.77, September 11, 2012)

Basics

  • Symbol: AVF
  • Principal Amount: $25
  • Coupon Rate: 7.7% or $1.925 before December 18, 2047. Three-month LIBOR plus 3.616% thereafter.
  • Call Date: December 18, 2012. AIG can redeem all ($1 billion), but not in part  before if a “tax event” happens or a “rating agency event” occurs anytime before December.
  • Mature Date: December 18, 2062, which can be extended to December 18, 2077
  • Distribution Dates: 3/18, 6/18, 9/18 & 12/18
Risks

  • Company: As mentioned in our last article, AIG is in great shape as they have gotten rid of the risky assets that plagued them during the financial crisis. Even during the financial crisis, this security continued paying a dividend. The company is still critical to the U.S. financial system.
  • Rank: This security is junior to all AIG senior debt. However, this should not be a problem as the company is in great financial shape.
  • Deferral of Interest: The company can defer interest payments up to 40 quarterly payments without giving rise to event of default. The deferred interest does accrue. They have and will probably never defer interest payments.
  • Call Date: The security can be called partially or fully after December 12, 2012. Currently, AIG is spending a lot of money buying its shares back, but if interest rates continue to decline, then it is possible they will at least partially call the security. Thus, it is important to buy it around the the principal amount.
Before September 13, 2012 (ex-dividend date), I would buy AVF at any price under $25.70. After the dividend, I would buy AVF at any price under $25.20 because the $.48 dividend in December is pretty much guaranteed.

Read the full prospectus here.

Disclosure: I do not own shares of AVF, but I may initiate a position within the next week. I am long AIG.