TSLX - Sixth Street Specialty Lending: A Top BDC For Income Investors

2023-11-20 23:25:07 ET

Summary

• Sixth Street Specialty Lending consistently pays special dividends due to strong Net Investment Income (NII) performance.
• TSLX has experienced a continuous upward trajectory in NAV over the past five quarters.
• TSLX's robust dividend coverage ratio, standing at around 133%, and a 1-year average NII coverage ratio of 126%, indicates a well-covered dividend with a relatively low risk of a dividend.

Sixth Street Specialty Lending ( TSLX ) has consistently proven itself as a top-performing BDC, regularly paying special dividends due to Net Investment Income [NII] consistently surpassing regular quarterly dividends. The BDC's portfolio, predominantly composed of senior secured debt, with a substantial portion in first lien senior secured debt, demonstrates effective sector diversification. Despite challenges with mark-to-market losses impacting Net Asset Value [NAV] per share, TSLX has experienced a consistent upward trajectory in NAV over the past five quarters, driven by excess NII and a rise in unrealized gains, reflecting the overall strength of its portfolio.

TSLX's robust dividend coverage ratio, standing at around 133%, and a 1-year average NII coverage ratio of 126%, indicate a well-covered dividend with a relatively low risk of a dividend cut. The BDC has benefited from rising interest rates, with over 99% of its investment portfolio consisting of floating-rate assets. While there is a potential risk of NII decline if interest rates decrease, the immediate future seems unlikely for substantial rate reductions. Considering these factors, the stock appears to be a promising investment for income investors.

The portfolio

The BDCs portfolio consists largely of senior secured debt with around 92% of its portfolio composed of first lien senior secured debt. Its portfolio is also reasonably diversified across various sectors with most sectors, except for the technology sector, making up less than 20% of its portfolio per sector.

NAV per share had previously been impacted by mark-to-market losses. These losses arose as volatility in the credit markers increased amidst rising rates. Volatility in this market has since declined substantially and over the course of the past five quarters, NAV has consistently witnessed an upward trajectory.

The upward trajectory in NAV was driven by excess NII as well as a rise in unrealized gains as the tightening of spreads saw an increase in the value of portfolio assets on a fair value basis. Management noted in this respect that -

…the underground portfolio from Q2 2022 has experienced fair values that have pulled towards par as first lien credit spreads have tightened 78 basis points. This has resulted in approximately $0.26 of uplift to net asset value per share. Second, we have generated net investment income in excess of our quarterly base and supplemental dividends which has contributed $0.31 to net asset value per share over the five-quarter period.”

The BDC has also continued to report low non-accruals with only 0.7% of its portfolio at fair value being on non-accrual status. No new non-accruals were added in the latest quarter while the BDCs internal risk weighting assigns an average rating of 1.17 for the portfolio as a whole based on a scale from 1 – 5 with 1 being the least likely to underperform on expectations.

Earlier this year Fitch observed in this respect that TSLX has consistently demonstrated strong asset quality trends since its inception. While Fitch anticipated a slight increase in non-accruals in 2023 due to higher debt service burdens for borrowers, it believes that TSLX's credit performance will remain above average. This is attributed to TSLX's predominant focus on first lien investments and its historically low levels of non-accruals. These predictions by Fitch have proven to be correct as non-accruals experienced only a slight uptick. In my view, the BDCs portfolio will likely continue to perform well in the quarters ahead given the prudent underwriting demonstrated so far.

Earnings and the dividend

TSLX currently offers a dividend yield of around 8.7% excluding the special dividends. This is the lowest of the major BDCs considered in the peer comp chart below but is quite a bit higher if special dividends were to be factored in.

In the most recent quarter TSLX reported adjusted NII per share of $0.6 which was well above the $0.45 per share ordinary dividend. This represents a dividend coverage ratio of around 133%. The BDCs 1-year average NII coverage ratio is also currently around 126% indicating that the dividend has persistently been well-covered by NII and the risk of a dividend cut is relatively low.

The BDCs NII has benefited significantly from the rise in interest rates with more than 99% of its investment portfolio being floating rate assets. When rates move lower again there is a risk of NII declining again. Nevertheless, I do not currently expect a substantial decrease in interest rates in the near future. At present most analysts are predicting that rates would only start lowering in 2024 as inflation in several key products and services remains somewhat elevated.

The pace of interest rate cuts are also unlikely to match the pace of interest rate hikes witnessed since 2022. Therefore, lowering interest rates are likely to have some negative impact on TSLX’s NII but this may be quite some time away from realisation. I do not accordingly view this as likely in the near term.

Valuation

TSLX is currently trading at a premium to NAV of around 24% which is the highest of the BDCs considered in the peer comp chart below. However, it is well below the BDCs 5-year average price to NAV of around 1.393. The discount to historical levels likely arose in part because of NAV declines in 2022.

The recent improvement in NAV might well contribute to a gradual rerating of the stock towards historic levels. Nevertheless, the uncertainty brought about by the interest rate environment justifies some level of discount to the historic average. In my view, it is worth considering the stock as long as its premium to NAV remains below 30%.

Conclusion

Sixth Street Specialty Lending has established itself as a top-performing BDC, consistently delivering strong financial performance and frequently paying special dividends due to NII exceeding regular quarterly dividends. The portfolio, primarily composed of senior secured debt with a significant portion in first lien senior secured debt, exhibits reasonable sector diversification, and good underwriting quality.

Despite previous challenges with mark-to-market losses impacting NAV per share, TSLX has experienced a notable upward trajectory in NAV over the past five quarters. This positive trend is attributed to excess NII and a rise in unrealised gains contributing to the overall value of portfolio assets. In my view, the improvement in NAV is a key component towards a long term rerating of the stock closer to historic valuation levels.

TSLX exhibits a robust dividend coverage ratio, providing confidence in the sustainability of dividends. While the majority of TSLX's portfolio consists of floating-rate assets, potentially posing a risk if interest rates decline, the outlook for interest rate decreases in the near term appears limited. Therefore, I currently consider TSLX a buy.

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