Prospect Capital's Strategic Shift to First Lien Loans: A New Paradigm for BDC Investors in a Rising Rate World

In the ever-evolving landscape of business development companies (BDCs), Prospect Capital Corporation (PSEC) has emerged as a case study in strategic adaptation. Over the past two years, the firm has systematically restructured its portfolio to prioritize first lien senior secured loans, a move that has significant implications for risk-adjusted returns and capital preservation—especially in a rising interest rate environment. For investors navigating the uncertainties of 2025, understanding this shift is critical to evaluating BDCs as a defensive asset class.

The Strategic Shift: From Subordinated to First Lien

Prospect Capital's portfolio transformation is stark. By June 30, 2025, first lien loans accounted for 70.5% of its investments at cost, up from 51.8% in 2022. This shift came at the expense of subordinated structured notes and second lien loans, which fell to 0.6% and 14.4% of the portfolio, respectively. The rationale is clear: first lien loans, which are secured by a borrower's assets and hold the highest priority in the capital structure, offer superior downside protection. Historical data underscores this, with U.S. senior loans averaging 63.5% recovery rates in default scenarios compared to just 40% for high-yield bonds.

This restructuring aligns with broader macroeconomic trends. As the Federal Reserve's rate hikes continue to ripple through the economy, BDCs must balance income generation with capital preservation. First lien loans, with their floating-rate coupons tied to SOFR, allow Prospect to benefit from rising rates while mitigating duration risk. In contrast, subordinated debt—often unsecured and issued to weaker borrowers—carries higher volatility and lower recovery prospects.

Risk-Adjusted Returns: A Double-Edged Sword

Prospect's shift has had mixed results on its financial metrics. While the firm's annualized current yield rose to 9.6% as of June 2025, its Net Investment Income (NII) per share declined from $0.25 in 2024 to $0.17 in 2025. This reflects the trade-off inherent in portfolio restructuring: higher-yielding first lien loans often come with lower leverage and tighter spreads, which can dampen short-term income. However, the long-term benefits are evident.

First lien loans have historically outperformed subordinated debt in rising rate environments. For example, during the 2022 rate-hiking cycle, U.S. senior loans delivered a 1% loss compared to a 13% drop in the broader bond market. This resilience is due to their floating-rate structure, which allows coupons to reset with benchmark rates, and their structural seniority, which reduces default risk. Prospect's focus on first lien loans thus positions it to weather economic headwinds better than peers reliant on riskier, lower-priority debt.

Capital Preservation: A Defensive Edge

Capital preservation is another area where Prospect's strategy shines. As of June 2025, the firm's non-accruals stood at 2.8% of total investments at cost—a figure consistent with industry peers but notable given the broader economic slowdown. This is a marked improvement from 2024, when the company reported $417 million in realized losses, largely from concentrated REIT investments. By shifting to first lien loans, Prospect has diversified its risk exposure and reduced reliance on illiquid assets.

The firm's leverage profile also supports capital preservation. With a net debt-to-asset ratio of 30.4% as of June 2025, Prospect maintains a conservative balance sheet, avoiding the over-leveraged pitfalls that have plagued some BDCs. This prudence is crucial in a rising rate environment, where liquidity constraints can amplify losses.

Implications for BDC Investors

For investors, Prospect's restructuring highlights the importance of aligning portfolio strategy with macroeconomic conditions. First lien loans offer a compelling risk-return profile in a world where fixed-rate assets are vulnerable to rate hikes. However, the transition is not without challenges. Prospect's NII decline and KBRA's downgrade to BB+ underscore the need for patience. The firm's real estate portfolio, for instance, remains a drag, with 58 properties yielding just 4.5% as of June 2025.

Investors should also monitor the firm's ability to execute its exit strategy for non-strategic assets. While Prospect has sold five REIT properties since 2024, the illiquid nature of real estate means full portfolio rotation will take time. A key metric to watch is the unlevered investment-level gross cash IRR of 24.0% for its real estate exits—a sign that disciplined asset management can offset short-term pain.

Conclusion: A Model for the New Normal

Prospect Capital's shift to first lien loans is a masterclass in strategic adaptation. By prioritizing senior secured debt, the firm has enhanced its resilience in a rising rate environment while maintaining a conservative leverage profile. For BDC investors, this case study underscores the value of structural advantages—such as floating-rate coupons and high recovery rates—in navigating economic uncertainty.

While the road ahead remains bumpy, Prospect's restructuring positions it to deliver stronger risk-adjusted returns over the long term. As the Fed's rate hikes continue to reshape the credit landscape, BDCs that follow Prospect's playbook—focusing on capital preservation and income stability—will likely outperform their peers. For investors seeking a defensive yet income-generating asset, the lessons from Prospect Capital are clear: in a world of rising rates, first lien loans are not just a strategy—they're a necessity.