Prospect Capital's Strategic Shifts Offer a Path to Reduced Dividend Risk Amid Mixed Credit Signals

Prospect Capital (NASDAQ: PSEC) has long been a bellwether for business development companies (BDCs), but its recent credit rating actions and strategic moves reveal a nuanced story of resilience and risk. While some agencies have reaffirmed its investment-grade status, others have downgraded it due to portfolio concentration and CLO losses. For investors, the key takeaway is that management's efforts to stabilize the capital structure and reduce dividend dependency may finally be bearing fruit—if not yet fully convincing the skeptics.

Mixed Signals from Credit Agencies
The year 2025 has seen Prospect Capital navigate a dual narrative. Morningstar DBRS and Egan-Jones reaffirmed its BBB-rated status, citing its diversified capital structure, low leverage (debt-to-equity of 0.40x), and a disciplined lending approach that prioritizes senior secured loans. These agencies highlighted its 13% unlevered IRR on exited investments and minimal nonaccruals (0.4%) as proof of operational strength. However, KBRA's downgrade to BB+ with a Negative Outlook underscored lingering concerns: a 42% concentration in control investments, including National Property REIT Corp. (which reported negative cash flow), and $517 million in CLO-related losses over two years.

The divergence reflects a broader debate: Can Prospect's strategic shifts offset its structural vulnerabilities?

Strategic Shifts: De-risking the Portfolio
Management has responded aggressively to KBRA's critiques. First, it has reduced exposure to concentrated REIT holdings by selling five properties in 2024 and shifting toward third-party senior secured first-liens, which now account for over 95% of 2025 originations. This pivot aligns with KBRA's recommendation to diversify away from illiquid, control-oriented investments. Second, the company cut its common dividend by 25% in November 2024, a move that reduced payout pressure and freed capital for deleveraging. Third, its revolving credit facility—extended to June 2029 with $974 million in availability—provides liquidity to weather near-term maturities.

The results are visible in its capital structure: gross leverage (including preferred stock) fell to 1.11x, and asset coverage rose to 183%, comfortably above the 150% regulatory minimum. These metrics suggest management is succeeding in its goal of stabilizing the balance sheet.

The Dividend Risk Equation
For income investors, the dividend cut is a double-edged sword. While it reduces payout sustainability risks, it also lowers near-term yield appeal. However, the long-term benefit is clearer: by aligning dividends with net investment income (which fell 25% in 2024), management has bought time to rebuild capital. The company's focus on first-liens—a sector with higher recoveries in downturns—could also reduce future shocks from CLO write-downs. Historically, investors who bought PSEC on its ex-dividend date and held for 30 days would have seen an average return of 7.78% from 2020 to 2025, though the strategy carried notable risks, including a maximum drawdown of -53.48% and a Sharpe ratio of 0.36, suggesting moderate risk-adjusted returns. These results highlight that timing around dividend events historically offered opportunities but required tolerance for volatility.

Backtest the performance of Prospect Capital (PSEC) when 'buy on ex-dividend date' and 'hold for 30 days', from 2020 to 2025.

Investment Implications
Prospect Capital's story is one of cautious progress. The dividend reduction and liquidity improvements have reduced the immediate risk of further downgrades or forced asset sales. However, KBRA's concerns about portfolio concentration and the slow pace of REIT exit remain valid. The company's market cap of $1.9 billion, down sharply from its peak, suggests investors are pricing in these risks.

For conservative investors, PSEC's current yield (~8%) and improved leverage metrics may offer value, especially if it continues to shed illiquid assets and grow its senior loan book. Aggressive investors might wait for clearer signs of portfolio rotation or a resolution of the REIT exposure. Meanwhile, the stock's volatility—evident in its 30% year-to-date decline—reflects the market's skepticism.

In the end, Prospect Capital's journey illustrates a broader truth: BDCs thrive when they balance yield ambition with capital discipline. For now, the signals are mixed, but the steps taken in 2025 suggest management is moving in the right direction—albeit slowly—to reduce its most pressing risks.

Investment advice: Consider PSEC for a cautiously allocated position in a diversified income portfolio, with a focus on long-term stability over short-term yield.