BDCX - PennantPark: Going All In Is A Recipe For Disaster

• Use PNNT for targeted floating rate exposure.
• If you're doubtful about the dividend, you have a good reason to be.
• Hedge your bets with treasuries.

Investment Thesis

In this article we review PennantPark Investment Corporation ( PNNT ) common shares. The stock can offer you a high current yield, but when you dig into the financials, there are some troubling data points. PNNT is a high yield, junk-quality play, so buy at your own risk.

Portfolio Strategy

PNNT is a player in the business development company ("BDC") industry in which they extend credit to private middle market companies. The portfolio is diversified between several different firms in various industries to spread out risk in the event of default. About 75% of the overall portfolio is invested in floating rate debt securities that are allocated between first, second, and subordinated levels. Of the 3, the majority is in secured first lien notes in which PNNT has first dibs in the event of borrower default.

The portfolio is floating rate, with the idea being to capture interest rate upside as the Fed raises rates to combat inflation. Indeed, while that can increase portfolio yield, the question becomes whether the portfolio companies can afford the rising coupon payments as their credit quality falls firmly in the "junk bond" category.

What To Know If You're In For the Dividend

At the time of this writing, PNNT offers a current yield of 9.16%, with dividends that are paid on a quarterly basis. Of course, that is a very competitive yield that can help most income investors achieve their goals. The question is whether it is a sucker yield in which it's difficult or almost impossible to earn an acceptable total return.

Indeed, you can see from the above chart that the PNNT dividend has been cut a few times over the past few years. While the response to Covid-19 was understandable, prospective investors must surely see the trend being illustrated. To their credit, it looks like they're trying to restore the dividend.

Digging into the financial statements reveals some interesting results. They have covered the dividend well from Net Investment Income ((NII)) without accounting for realized/unrealized capital divestments. This is, of course, a very good thing. However, when you plot the Net Investment Income you can see a troubling trend over the years.

Hedge Your Bets, People!

While the dividend can be tempting, prospective investors should be thinking about achieving an acceptable total return . Considering the historical performance of PNNT, that would've been darn near impossible without impeccable market timing. Indeed, in light of all the less rosy data points of PNNT, you can easily see why the market has discounted the stock.

I wouldn't write this one off entirely and do think that PNNT does deserve a spot in your portfolio if you're seeking high current income and are willing to hedge with diversified exposure to an uncorrelated asset class (long duration treasury bonds). You can see from the image above that maintaining exposure to ZROZ would have stabilized performance when there was blood in the streets and PNNT was down 65% during the Covid-19 Crash!

Summary

All things considered, I can get behind purchasing PNNT for the sake of generating current income. But the stock is risky and the data points are trending in the wrong direction. Be prepared for the inevitable volatility and hedge your bets with treasury bonds.

For further details see: