Evaluating Palmer Square Capital BDC's Dividend Strategy Amid Declining Net Investment Income and Portfolio Volatility

In the second quarter of 2025, Palmer Square Capital BDC (NYSE: PSBD) reported a net investment income (NII) of $0.43 per share, a modest decline from $0.48 in the same period of 2024. This reduction, attributed to macroeconomic volatility and a 100-basis-point rate cut in late 2024, raises critical questions about the sustainability of its dividend strategy. PSBD's dividend structure—comprising a base payout of $0.36 per share and a supplemental $0.06 per share—has historically provided a robust yield of 11.1% for income-focused investors. However, the narrowing margin between NII and dividend obligations, coupled with portfolio turbulence, demands a closer examination of its strategic intent and long-term viability.

Dividend Structure: A Hybrid Approach to Income Stability

PSBD's dividend policy is designed to balance consistency with flexibility. The base dividend of $0.36 per share, payable quarterly, is supported by a trailing NII coverage ratio of 1.19x ($0.43 NII vs. $0.36 dividend). While this ratio exceeds the 1x threshold for sustainability, it leaves little room for volatility. The supplemental dividend, funded by excess NII or non-recurring gains, acts as a buffer to maintain total distributions. For Q2 2025, the $0.06 supplemental dividend was declared from excess NII, reflecting the company's ability to adapt to quarterly earnings fluctuations.

This hybrid model mirrors broader trends in the BDC sector, where firms like Goldman Sachs BDC (GSBD) and Ares Capital (ARCC) have similarly adopted layered dividend structures to navigate tightening credit markets. However, PSBD's reliance on supplemental payouts introduces a key risk: if NII declines further due to rate cuts or portfolio defaults, the company may struggle to fund these additional distributions without tapping into capital reserves.

Portfolio Resilience and Credit Quality

PSBD's portfolio, valued at $1.28 billion as of June 30, 2025, is a cornerstone of its dividend strategy. The portfolio's weighted average yield of 10.10% (at fair value) and 98% floating-rate exposure position it to benefit from rising interest rates. Additionally, 96% of the portfolio is senior secured, with an average hold size of $5.1 million, reducing default risk. The company's internal credit scoring system, which assigns a 3.6 average rating (on a 1–5 scale), further underscores its disciplined underwriting.

Nonetheless, the portfolio faces headwinds. The 100-basis-point rate cut in late 2024 directly impacted PSBD's floating-rate loan portfolio, reducing total investment income by 13.7% year-over-year. While the company's liquidity of $253.5 million and conservative debt-to-equity ratio of 1.51x provide a buffer, the 0.19% nonaccrual ratio and 2.53% PIK income highlight potential vulnerabilities in a prolonged downturn.

Comparative Analysis: PSBD vs. Peers

PSBD's dividend strategy contrasts with peers like GSBD, which reduced its base dividend to $0.32 per share in Q2 2025 but introduced a special $0.16 payout. While GSBD's approach prioritizes capital preservation, PSBD's focus on maintaining a high base yield (11.1%) reflects its positioning as an income-centric BDC. However, this comes at the cost of higher leverage (1.51x vs. GSBD's 1.12x) and a 7.7% discount to NAV, which could widen if market conditions deteriorate.

Ares Capital (ARCC), with its 8.5% yield, offers a more conservative profile but faces similar risks from floating-rate exposure. PSBD's higher yield is attractive, but investors must weigh it against the company's declining NII and sensitivity to rate cuts.

Strategic Intent and Market Positioning

PSBD's management has emphasized active portfolio rotation as a defensive strategy. In Q2 2025, the company deployed $92.4 million in new investments while exiting $133.3 million in existing positions, leveraging its parent company's $35-billion platform to identify relative value opportunities. This agility is critical in a volatile market, as evidenced by the portfolio's quick recovery from April 2025's geopolitical-driven spread widening.

However, the company's European investments—18% of new Q2 deals—introduce currency and regulatory risks. While U.S. dollar-denominated loans mitigate some of these concerns, the geographic diversification could complicate liquidity management during a crisis.

Investment Implications and Recommendations

For income-focused investors, PSBD's 11.1% yield remains compelling, particularly in a low-yield environment. The company's high-yield, floating-rate portfolio and disciplined credit strategy provide a strong foundation for sustaining distributions. However, the declining NII and reliance on supplemental dividends necessitate caution.

Key Considerations for Investors:
1. Monitor NII Trends: A further decline in NII could force PSBD to reduce or eliminate supplemental dividends, impacting total returns.
2. Assess Portfolio Durability: The company's ability to maintain its 10.10% yield and low default rates will be critical in sustaining the base dividend.
3. Evaluate Rate Sensitivity: If the Federal Reserve initiates rate cuts in 2025, PSBD's floating-rate exposure could erode margins, requiring proactive portfolio adjustments.

In conclusion, PSBD's dividend strategy is a double-edged sword: it offers an attractive yield supported by a high-quality portfolio but carries risks tied to declining NII and macroeconomic volatility. Investors should prioritize diversification and maintain a long-term perspective, recognizing that PSBD's hybrid dividend model is best suited for those seeking income with a tolerance for moderate risk.