OCSL - Growing 11+% Yields For Retirement: Ares Capital And Oaktree Specialty Lending

2023-06-28 08:00:00 ET

Summary

• BDCs can be powerful investments for retirees living off of passive income.
• ARCC and OCSL are among the best passive income instruments in the market today.
• We compare them side by side.

Investing for passive income from blue chip Business Development Companies ( BIZD ) is a powerful approach to funding one's retirement. This is because living off of the cash flow from stable, defensive, cash-flowing businesses like investment grade BDCs with well-diversified and conservatively underwritten portfolios of senior-secured loans can enable retirees to:

• Sleep well at night in the midst of market volatility with a high degree of confidence that their cash flow stream will continue to flow in.
• Generate more than enough income to fund their living expenses from their dividends, enabling them to reinvest the excess cash flow to further grow their income stream and offset the eroding power of inflation.
• Not have to sell their shares at inopportune times since their cash flow covers all of their expenses.
• Be relatively inflation and interest rate agnostic since BDCs see their earnings rise when interest rates rise.
• Potentially outperform the market over the long-term.

In this article, we will look at two of the most attractive defensive double-digit yielding BDCs at the moment: Ares Capital ( ARCC ) and Oaktree Specialty Lending ( OCSL ).

ARCC Stock Vs. OCSL Stock: Investment Portfolios

Both ARCC and OCSL are fairly defensively positioned with strong underwriting performance. ARCC has 64.4% of its portfolio invested in 1st and 2nd lien senior secured loans and OCSL has 84.3% of its portfolio invested in the same. Both are also positioned to benefit from rising interest rates with asset sensitivity to interest rates. ARCC benefits more from rising interest rates than OCSL does given that OCSL intentionally has more of its debt set at floating rates given that it strives to be relatively interest rate agnostic. That said, it still does benefit some from rising interest rates.

Their underwriting performance is also strong, with ARCC's non-accruals at a very low 1.3% of fair value and OCSL's non-accruals are at a very reasonable 2.4%, though management believes these are unique investment-specific issues and do not reflect broader risk of the non-accrual rate rising in the coming quarters.

ARCC benefits from its large scale and relationship with its manager, the large global alternative asset management platform from Ares Management ( ARES ). As a result, it is able to partner with ARES' other credit platform funds to invest in larger middle market companies which generally have better competitive advantages and reportedly enjoy better access to credit than their smaller counterparts.

OCSL meanwhile benefits from its relationship with the storied Oaktree led by the legendary Howard Marks as well as Brookfield ( BN )( BAM ) which has a flourishing credit and direct lending business.

ARCC Stock Vs. OCSL Stock: Balance Sheets

Both businesses enjoy investment grade credit ratings and have solid balance sheets with moderate leverage and plenty of liquidity.

ARCC's leverage ratio was at 1.09x at the end of Q1, which is on the lower end of its target leverage range while OCSL's leverage ratio was also at a very reasonable level of 1.14x. This means that both businesses are well-positioned to deal with potential spikes in non-accruals if the economy deteriorates further as they both can afford to have leverage move up a bit without it compromising their balance sheet stability.

ARCC Stock Vs. OCSL Stock: Dividend Profile

Their dividend profiles have been quite strong in recent years. Over the past two years alone, ARCC's base quarterly dividend has grown by 20% alongside some fairly generous special dividends. On top of that, it has not cut its dividend since the Great Financial Crisis and has grown it by over 37% over the past 12 years, whereas many of its peers have had to cut their dividends at least once over that span.

OCSL has a fairly spotty long-term track record, but since Oaktree took over managing the fund in late 2017, its performance has been phenomenal. Since the beginning of 2018, its total return performance has roughly doubled that of the broader BDC sector and its quarterly base dividend has grown by a whopping 116%.

Moving forward, both dividends appear safe and have the potential for further growth. ARCC's dividend was covered 1.24x by net investment income in its most recent quarter and also benefits from considerable spillback income. OCSL, meanwhile, covered its dividend 1.13x during its most recent quarter, which is also quite conservative, especially given that OCSL has more protection against falling interest rates and a more conservatively positioned portfolio than ARCC does.

On their latest earnings call, OCSL's management had this to say about their dividend:

I think we've also been very conservative in our approach to the dividend...We have increased it really almost double the pre pandemic level, but at this point, the dividend yield on NAV is north of 11%. Our ROE for the quarter was north of 12.5%. So we feel very good about the dividend coverage, very good about the earnings and the ROE, but just kind of given all the uncertainty out there it seem to make sense to just keep at $0.55...So that's really kind of how we thought about the dividend for this quarter.

That seems to imply that OCSL's current base payout level is quite conservative and could potentially move even higher depending on how economic conditions shift moving forward. Given that the yield is currently 11.7% and the payout is considered quite safe, there really is no need for additional dividend growth to deliver an attractive return for shareholders.

ARCC meanwhile had this to say about its dividend:

We continue to consider our taxable income and the amount of spillover when set an overall dividend. Our current estimate of undistributed taxable income sometimes referred to as our spillover. At year-end 2022 is $650 million or approximately $1.19 per share.

This 2022 spillover level is nearly 2.5x greater than our current regular quarterly dividend rate.

We continue to believe that having a healthy level of spillover income is beneficial to the long-term stability of our dividend. We will continue to monitor our undistributed earnings and balance these levels against prudent capital management considerations.

Once again, this dividend sounds quite secure for the foreseeable future and, with a current yield of ~10.5%, not much growth is needed in the dividend to produce an attractive total return for shareholders.

ARCC Stock Vs. OCSL Stock: Valuation

When it comes to valuation, both currently offer very attractive yields that remove any need for multiple expansion or growth to generate more than satisfactory returns for shareholders. On top of the dividend, however, ARCC currently trades at a ~1% discount to NAV and OCSL trades at a near 5% discount to NAV. Given that ARCC often trades at slight premium to NAV and OCSL has recently traded roughly in-line with NAV, there is some multiple expansion potential that could further boost total returns beyond the dividend.

On top of that, both businesses are retaining cash and using it reinvest in their businesses, so there could be additional total return generation from NAV per share growth as well. Of course, if the economy continues to slide towards recession, non-accruals may increase and NAV erosion could offset the retained earnings. Still, both businesses are well-positioned to deliver double-digit annualized total returns to shareholders for the foreseeable future.

ARCC Stock Vs. OCSL Stock: Investor Takeaway

Both of these stocks offer investors well-covered double-digit dividends that appear to be quite well protected even if the economy slides into a recession. Moreover, with a small margin of safety in their price to NAV ratios and a meaningful amount of retained earnings net of dividends, there appears to be a clear path to delivering total returns on top of the lucrative dividend income stream. As a result, we think both are suitable investment for just about any investor, but these stocks may be particularly useful for retirees looking to juice their passive income stream, especially as a complement to a core dividend growth holding like the Schwab U.S. Dividend Equity ETF ( SCHD ). As a result, we hold these BDCs along with several others in our Retirement Portfolio at High Yield Investor.

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