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It’s easy to become jaded with many high yielding opportunities available on the market today, especially in the BDC segment. However, for those who remain focused on growing their income, I continue to believe that we are currently amidst a once in a multi-year buying opportunity for high yielding stocks.
This brings me to PennantPark Floating Rate Capital (NYSE:PFLT), which remains in bargain territory with a high yield above 10%. This article highlights why PFLT just may be an under-covered gem for income investors, so let’s get started.
Why PFLT?
PFLT is an externally-managed BDC that’s advised by PennantPark Investment Advisers, and invests in U.S. middle-market companies in the form of floating rate senior secured loans, including first lien (over 85% of portfolio), second lien, and subordinated debt.
PFLT’s portfolio is well-managed and overall safe, with just 2 loans out of the total 125 investments on non-accrual at the end of September, representing just 0.9% of portfolio cost and 0.01% of portfolio fair value. While its book value did decline by 4.8% during the fourth quarter (ended Sep. 30th), most of that was due to mark to market adjustments in the current volatile macro-economic environment, as what many other BDCs have seen.
Importantly for income investors, the $0.095 monthly dividend is covered by the $0.30 in core net investment income generated during the fiscal fourth quarter. PFLT is also modestly leveraged, with a statutory debt to equity ratio of 1.29x, sitting below the 2.0x regulatory limit
Looking forward, PFLT stands to benefit from rising rates as 100% of its portfolio is floating rate. It’s already seen some of that benefit, as the weighted average yield to maturity on its portfolio increased by 150 basis points sequentially to 10%, from 8.5% in the prior quarter. Management estimates that every 100 basis point increase in base rates translates into $0.03 in NII per share accretion.
PFLT’s portfolio companies are also taking caution in the current environment, with 2022 and 2023 portfolio loans expected to have lower leverage at the borrower level while also carrying higher debt covenants for PFLT’s benefit. At present, interest coverage ratio remains strong among portfolio companies, with an average 3x coverage ratio.
Meanwhile, PFLT maintains a fee-friendly structure, with a 1.0% base management fee on adjusted gross assets (net of cash), sitting below the 1.5% rate for industry bellwether Ares Capital (ARCC). Management also holds a long-term view with a focus on direct lending, which results in a closer relationship with the borrower. This 3-year strategy is supported by management comments during the recent conference call:
In times of market volatility, our direct lending strategy focuses on creating value from the dislocation in the markets. Specifically, we’ve been active buying first lien loans in the secondary market at discounts in companies where we believe we have differentiated institutional knowledge. It could be a company that we used to finance and a sector where we have domain expertise or direct relationship with the management team or a financial sponsor. We have been buying loans where we think we can generate double-digit or low teens IRRs as the loans return to par in 3 years. We employed a similar strategy during the global financial crisis and generated excellent returns.
Because we are an important strategic lending partner, the process and packaging terms we receive is attractive. We have many weeks to do our diligence with care. We thoughtfully structured transactions with sensible credit stats, meaningful covenants, substantial equity cushions to protect our capital, attractive upfront fees and spreads and equity co-investment. Additionally, from a monitoring perspective, we received monthly financial statements to help us stay on top of the companies.
With regard to covenants, virtually, all of our originated first lien loans have meaningful covenants which help protect our capital. This is one reason why our default rate and performance during COVID was so strong and why we believe we are well positioned in this environment.
Lastly, I see value in the stock at the current price of $11.29, equating to a price to book value of 0.97x. This is considering the quality of the portfolio with experienced management team and the attractive 10.0% dividend yield that’s covered by core NII. Analysts have a consensus Buy rating with an average price target of $12.63, translating to a potential 22% total return including dividends.
Investor Takeaway
PFLT is an attractive BDC at the current price and pays a juicy 10% dividend yield that’s covered by core NII. With a portfolio of floating rate loans, PFLT stands to benefit from rising rates. Additionally, it has a fee-friendly management structure and a long-term view on direct lending to create value from market volatility. As such, investors should consider adding PFLT at the current price for potentially strong income and returns.
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