Prepare to Earn a Double-Digit Return
Not everyone wants higher interest rates. For homeowners, rising rates could translate to higher mortgage payments. For corporations, higher interest rates would increase their debt repayment burden.
However, it’s not all going to be bad news, because there are strategies for investors to capitalize on rising interest rates. Since we are Income Investors, I’m going to show you a relatively safe one. With this play, there’s no need to use complicated financial derivatives. And you get paid a double-digit income stream just to be part of the game.
Sounds too good to be true? Well, let me explain.
In order to take profit from higher interest rates, you need to keep track of two simple variables: revenue and expenses. If you can increase your revenue when interest rates increase while keeping your expenses fixed, chances are you’ll see more profits on the bottom line.
As it turns out, one company is well positioned to do exactly that: Prospect Capital Corporation (NASDAQ:PSEC).
Headquartered in New York City, Prospect Capital is a business development company, or BDC. Its main business is to invest in middle-market companies in the U.S., most through debt financing. In other words, PSEC lends out money and collect interest payments.
Here’s the neat part: as of June 30, 2017, approximately 90.4% of Prospect Capital’s interest-bearing assets are floating-rate, while only 9.6% are fixed-rate. So, when interest rates increase, as they have been doing for the past two years, the company would most certainly generate higher interest income.
Interest-Bearing Assets
Source: “Prospect Capital Corporation,” Prospect Capital Corporation, last accessed October 3, 2017.
Obviously, if the company also has a lot of floating-rate liabilities, the higher-interest income would be offset by higher-interest expenses.
The good news is that 99.9% of Prospect Capital’s liabilities are fixed-rate. So, if interest rates increase, its interest expenses would largely stay the same.
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Liabilities
Source: “Prospect Capital Corporation,” Prospect Capital Corporation, last accessed October 3, 2017.
So, what we have here is a company that is bound to make more profit in a rising-interest-rate environment. And the story gets even better. Rather than waiting for that higher profit to be realized in the future, investors can already earn a more-than-decent return today through the company’s generous distributions.
Prospect Capital currently pays monthly dividends of $0.06 per share. At today’s price, that translates to an annual yield of 10.7%.
The reason why the company can afford to pay oversized dividends is its already-profitable business. By the end of the second quarter, the annualized yield of Prospect Capital’s portfolio stood at 12.2%. (Source: “Prospect Capital Reports June 2017 Annual and Quarterly Results and Declares Distributions for October and November 2017,” Prospect Capital Corporation, August 28, 2017.)
Furthermore, the company focuses on senior and secured lending, which adds a level of safety to its cash flow and distributions.
Of course, Prospect Capital’s business is probably not as solid as the well known dividend giants like Johnson & Johnson (NYSE:JNJ) and Proctor & Gamble Co (NYSE:PG). However, neither company offers a yield even remotely close to what Prospect Capital is paying. For investors who are looking for a high-yield stock that could do well in a rising interest rate environment, companies like Prospect Capital Corporation could be a good place to start looking.