OCSL - Better 10%+ Yield: Blue Owl Capital Corp Or Oaktree Specialty Lending?

2023-10-08 07:00:00 ET

Summary

• BDCs have proven to be valuable portfolio diversifiers in a rising rate environment for income investors.
• We compare two of the cheaper and more defensively positioned BDCs.
• We offer our take on each one's strengths and weaknesses relative to each other.

Business Development Companies ( BIZD ) have become increasingly popular instruments with income investors given that their balance sheet leverage is on par with or even lower than that of many REITs ( VNQ ), they invest primarily in senior secured debt which enjoys a superior spot in the capital stack to that of most equity REITs, and - best of all - the vast majority of BDCs generate higher earnings when interest rates rise. This makes BDCs a terrific portfolio diversification tool for investors who also want to invest in other high-yield instruments like REITs, Utilities ( XLU ), and MLPs ( AMLP ).

While soaring energy prices and a renewed focus on energy security in the wake of the war in Ukraine that began in early 2022 has driven massive outperformance in the MLP space, the chart below shows how BDCs have significantly outperformed Utilities and REITs since rates began rising in early 2022:

That being said, with long-term interest rates rising rapidly in recent weeks, concerns are growing over a potentially severe recession hitting the U.S. economy. In such a scenario, BDCs - which tend to lend money to middle-market businesses that often have less than stellar balance sheets - may begin to suffer if a sharp economic downturn results in growing non-accruals and defaults in their portfolios. As a result, we think it is prudent for investors to begin focusing on some of the more defensive names in the BDC space in order to minimize the risks to investor principal should a recession indeed manifest itself.

In this article, we compare two of the least expensive, yet more defensively positioned BDCs - Blue Owl Capital Corp ( OBDC ) and Oaktree Specialty Lending ( OCSL ) - and offer our take on which is the better buy at the moment.

OCSL Stock Vs. OBDC Stock: Investment Portfolios

Both businesses invest primarily in senior secured loans and have thus far exhibited strong underwriting performance, making them both among the more defensive options in the BDC sector.

OCSL's investment portfolio reflects a robust and defensively positioned strategy. A substantial 87.1% of its assets are allocated to 1st and 2nd lien senior secured loans, including a whopping 75.5% in 1st lien loans. This allocation reflects Oaktree's traditional emphasis on risk mitigation and avoiding losing positions, as senior secured loans offer a higher degree of protection in the event of borrower defaults. It is also interesting to note that - unlike many of its peers - OCSL takes a more neutral approach to the direction of interest rates. While 83.6% of the loans in its investment portfolio are floating rate, nearly an equal amount of its outstanding debt (83.2%) is floating rate. With its only fixed-rate debt not maturing until 2025, OCSL is unlikely to face as many headwinds to its bottom line if/when the Federal Reserve pivots to cutting interest rates during an economic downturn.

OCSL's stellar underwriting performance is reflected in its meager 0.8% non-accrual rate on a fair value basis.

OBDC's investment portfolio mirrors OCSL's conservative posture, placing a significant emphasis on senior secured loans with 83.2% of its portfolio allocated to 1st and 2nd lien loans (69.1% in 1st lien loans and 14.1% in 2nd lien loans). While not quite as conservative in nature as OCSL's, OBDC's portfolio is not far behind. OBDC has greater exposure to interest rate volatility as only 41.8% of its debt is floating rate, meaning that if/when the Federal Reserve starts to cut rates again, it will be losing net investment income as its floating rate loan income will fall more dramatically than its interest expense on its debt.

OBDC also has stellar underwriting performance with a near-identical non-accrual rate to OCSL's at 0.9% on a fair value basis.

Overall, we see that OCSL gets the edge over OBDC in terms of its defensive characteristics as reflected by its greater allocation to 1st lien and senior secured debt, more interest rate neutral approach to its balance sheet, and its slightly better underwriting performance.

OCSL Stock Vs. OBDC Stock: Balance Sheets

The financial health of a BDC is a critical aspect of investment analysis, and the balance sheet plays a pivotal role in assessing a company's stability as well as its ability to sustain its dividend through good times and bad.

OCSL maintains a prudent leverage ratio of 1.14x as of the end of last quarter, leaving it enough flexibility to deal with deteriorating economic conditions while still giving it a strong return on equity.

OBDC has an identical leverage ratio to OCSL's, and both of these BDCs also enjoy investment grade credit ratings, giving them access to debt on reasonable terms.

OCSL Stock Vs. OBDC Stock: Dividend Profile

Given that BDCs are pass-through entities that are known for the high yields that they pay out, understanding the dividend outlook is essential when determining whether or not to invest in one.

OCSL's dividend growth has been phenomenal since Oaktree assumed management responsibility several years ago:

This is in large part due to management effectively recycling capital from lower yielding loans into higher yielding loans that were underwritten by Oaktree, thereby achieving even better underwriting performance while also generating superior income for investors.

Moving forward, OCSL will likely slow dividend growth as it has largely completed its loan recycling program and interest rates are near or at their peak. That said, the current dividend is sufficiently covered at a 1.13x ratio, combining with the strong balance sheet and investment portfolio to provide a pretty reliable dividend payout even if a mild recession should hit.

OBDC meanwhile, covers its total dividend payout by an even more conservative ratio of 1.2x and - when subtracting its special dividend - its regular dividend of $0.33 was covered even more easily at a 1.45x ratio. For a BDC with a fairly conservative balance sheet and investment portfolio, OBDC has a very sustainable regular dividend payout and even could potentially grow it a bit more moving forward.

OCSL Stock Vs. OBDC Stock: Valuation

When it comes to valuation, OBDC is significantly cheaper than OCSL, trading at a 12.39% discount to NAV at the moment compared to OCSL's more modest 3.63% discount to NAV. That said, OCSL has a much higher dividend yield of 11.66% compared to OBDC's dividend yield of 9.87%. Annualizing their most recent quarter's net investment income gives OCSL a P/NII of 7.7x and OBDC a P/NII of 7.0x. As such, we can conclude that OBDC is about ~10% cheaper than OCSL on both a P/NAV and P/NII basis, though it is more cautious in the quarterly dividend that it pays out to shareholders and instead opts for special dividends to supplement its quarterly dividend.

Investor Takeaway

Both of these BDCs are quite high quality and well-positioned to deal with an economic downturn. OCSL benefits from the pedigree that comes with the Oaktree name and its famous Chairman Howard Marks. Moreover, its portfolio is slightly more conservatively positioned and is better positioned to deal with a decline in interest rates than OBDC is. Finally, its quarterly regular dividend is meaningfully higher than OBDC's is while still being reasonably well covered by NII.

That said, OBDC is considerably cheaper than OCSL is and its regular quarterly dividend is much better covered by NII. Overall, for investors looking to maximize yield while guarding against downside to NAV and NII, OCSL is the better pick. However, for investors looking to maximize total returns, OBDC likely offers slightly more upside potential relative to incremental risk. We rate both as Buys.

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