2023-11-16 08:05:00 ET
Summary
- Oaktree Specialty Lending is a solid income pick for a choppy market, offering a high yield that's covered by NII.
- It offers exposure to technology and healthcare segments, among others, and has high floating rate exposure in debt investments.
- OCSL has demonstrated steady fundamentals, holding a steady NAV per share over the past 4 quarters.
Investing for total returns can be nice, but when it comes to low-yielding stocks, it's worth bearing in mind that much of those total returns can be locked in the form of unrealized gains. Since stocks can be wildly overvalued at times, those unrealized gains may not be as durable as it may seem.
That's why it's important to also focus on 'payback period', which is the length of time it takes for dividends to offset the principal amount that you've invested, and this is where BDCs shine. BDCs can be especially useful, as part of a well-diversified portfolio, for those who are trying to implement a '4% rule' of cashing out 4% of their retirement assets per year to fund living expenses. Since many pay yields well above 4%, investors can collect a high yield without having to sell shares.
This brings me to Oaktree Specialty Lending (OCSL), which I last covered here back in September. The market has seen its fair share of ups and downs since then, and OCSL is down just 1.5% since my last piece, slightly underperforming the 1% rise in the S&P 500 ( SPY ) over the same timeframe, although that could quickly change as OCSL dividend payments start kicking in, contributing to a 'realized' total return.
In this piece, I provide an update including OCSL's recent quarterly earnings and discuss why OCSL remains a solid income pick for a choppy market, so let's get started!
Why OCSL?
Oaktree Specialty Lending is a sizable BDC that's externally managed by Oaktree Capital Management. It came to its current form from the merger of OCSL and OCSI (Oaktree Strategic Income), which resulted in cost synergies and greater scale. At present, OCSL carries $2.9 billion in investment value comprised of 143 portfolio companies.
Three-quarters (76%) of OCSL's investments are in the form of first lien secured loans, which sit at the top of the capital stack, with another 10% being in the form of second lien secured loans. While secured loans carry a lower interest rate compared to unsecured loans, they give a better chance of principal recoupment in the event of a borrower default.
OCSL is also well-diversified with higher exposure to technology and healthcare-related companies. As shown below, these segments are well represented among OCSL's top industries alongside Industrial, Real Estate, Specialized Finance, and Retail.
Importantly, OCSL has done well under Oaktree's management, by growing its dividends and holding a steady NAV per share over the past 4 quarters. While the NAV/share did decline last year, that was due to unrealized losses from widening credit spreads as private markets revalue debt investments in a higher interest rate environment.
Meanwhile, OCSL has demonstrated steady fundamentals during its recently closed fiscal Q4 2023, as NAV/share grew by $0.05 on a sequential basis to $19.63. OCSL also continues to out-earn its dividend with net investment income per share of $0.62, equating to a NII-to-dividend coverage ratio of 1.13x. This also helped OCSL to cap off the fiscal year 2023 with NII/share of $2.51, up from $2.45 in the prior year, driven by higher total investment income.
Also encouraging, OCSL's investments on non-accrual declined by 120 basis points on a sequential basis to 2.4% of portfolio cost (1.8% of portfolio fair value), and floating rate debt investments remain steady at 86% of the portfolio, putting OCSL in position to continue benefitting from the higher interest rate environment. This is reflected by OCSL's 12.7% weighted average yield on debt investments during fiscal Q4, up from 12.4% in the prior quarter.
Risks to OCSL include potential for lower interest rates should the U.S. head into a recession, as this would lower the effective yield on OCSL's debt investments. It's hard to say when and if rate cuts will occur, with some investment banks like UBS ( UBS ) expecting rate cuts of as much as 275 basis points next year while Goldman Sachs ( GS ) expects for the Federal Reserve to hold off on cutting interest rates until Q4 of next year.
Another risk is from the added stress that higher interest rate has put on borrowers, as many took on their loans when rates were lower. However, this could turn into an opportunity for OCSL given Oaktree's track record of investing in the distressed debt market, as noted by the CFO during the recent conference call :
By the end of the third calendar quarter, loans with credit ratings of B or below represented almost 75% of U.S. leveraged loans compared to roughly 35% prior to the financial crisis. When the weakest segment of the credit markets is both sizable and more vulnerable than usual, investors face a heightened risk of increased defaults and lower than anticipated recovery rates.
If this were to happen, both performing and distressed credit investors are likely to encounter an expanded set of challenges and opportunities. At Oaktree, as we have navigated through many economic cycles, we've gained valuable experience that has allowed us to capitalize on opportunities, which is why we are optimistic about what might be ahead for OCSL.
OCSL is well-positioned to capitalize on investment opportunities as it carries a reasonably low amount of leverage with a debt to equity ratio of 1.1x, sitting below the 2.0x statutory limit. It also has $1.04 billion of liquidity and no debt maturities until 2025, giving it financial flexibility over the next year.
OCSL Debt Maturities (Investor Presentation)
Lastly, I don't view OCSL as being expensive at the current price of $19.93, representing just a 1.5% premium to NAV per share of $19.63. As shown below, this sits within OCSL's valuation range over the past 2 volatile years for the economy, and this valuation sits between its two large peers Ares Capital ( ARCC ) and Blue Owl Capital Corp. ( OBDC ). Considering OCSL's 11% dividend yield that's well-covered, I view it as being good value at present for its high yield and potentially quicker payback period compared to lower yielding investments.
OCSL vs. Peers' Price to Book (Seeking Alpha)
Investor Takeaway
In summary, OCSL looks like a good pick for high-yield investors looking to generate steady income from private debt investments. Its well-diversified portfolio, strong fundamentals, and experienced management team make it an attractive option in the BDC space. With shares trading at just a slight premium to NAV, OCSL offers good value with an 11% dividend yield. As such, I maintain a 'Buy' rating on the stock.
For further details see:
Oaktree Specialty Lending: Forget 4% Rule, Collect 11% Instead