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Prospect Capital Corporation (PSEC): Big Dividend, Big Risks

And while ROE is perhaps a more comprehensive performance measurement than the popular net investment income (NII) because, unlike NII, ROE also captures net realized gains and losses, ROE can be misleading. Specifically, as this next chart alludes to, NII/NAV is declining, not necessarily because NII is declining (although it has in the last three quarters, more on this later) but because NAV has been increasing (relative to NII) as distressed assets purchased at distressed prices recover (and as management is perversely incentivized to grow AUM, more on this later).

And the distressed assets have recovered not just because of PSEC’s great underwriting standards, but also because of where we are in the market cycle (i.e. the market/economy has recovered, and while this is out of PSEC’s control, PSEC has certainly benefitted).

For added perspective, this next chart shows Prospect’s declining ROE in recent years as we move further away from the financial crisis vintage year originations/investments.

Worth considering, PSEC trades somewhat similarly to publically-traded high-yield debt as represented by ticker JNK and shown in the following correlation table.

Specifically, PSEC has a higher correlation to high yield debt over the last five years than it has to the S&P 500 (SPY) or to small cap stocks (IWM), which makes sense considering the types of loans PSEC is actually making (i.e. the loans, and equity investments, are being made to relatively higher-risk middle market companies). And for further perspective, high-yield bonds just had a great 2016 (and a great 8-year run, following the financial crisis) which suggest, from a contrarian standpoint, high-yield may not perform as well going forward and neither will Prospect.

For more perspective, this next chart shows the spread (versus Treasuries) for high-yield bonds has come down a lot since the financial crisis (and since early 2016 for that matter- which is important because PSEC was a lot cheaper at the start of 2016), and this suggests Prospect will likely not be able to make the same juicy-yielding investments it made during the financial crisis which it has also benefitted from in recent years because those loans lasted more than just a year or two as inferred from our earlier vintage year chart.

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