2023-08-15 15:30:42 ET
Summary
- Oaktree Specialty Lending Corporation offers a solid 11% yield, but the stock is currently not a buy.
- The BDC experienced a decline in credit quality in the second quarter but still managed to cover its dividend easily.
- The discount to net asset value has disappeared, and Oaktree Specialty Lending now sells at a 2% premium.
Business development company Oaktree Specialty Lending Corporation ( OCSL ) offers passive income investors a solid 11% yield, covered by net investment income, but the stock is currently not a buy, in my view.
The BDC experienced a decline in credit quality in the second quarter but still managed to cover its dividend with (growing) adjusted net investment income easily.
Furthermore, the discount to net asset value, which I thought was a great reason to buy the BDC on the cheap before, has completely disappeared, and Oaktree Specialty Lending now sells at a 2% premium to net asset value.
With a NAV discount no longer available to passive income investors, a downgrade must follow.
Oaktree Specialty Lending's Portfolio Composition In 2Q-23
No major change in portfolio composition has occurred in the second quarter, and Oaktree Specialty Lending remained widely overweight First and Second Liens.
At the end of the second quarter, Oaktree Specialty Lending had 76% of its investments allocated to First Liens and 12% to Second Liens. Unsecured Debt, Equity and Joint Venture Investments accounted for the remaining 12% of investments, on a fair value basis. In total, Oaktree Specialty Lending had $3.1 billion invested across 156 portfolio companies in the second quarter.
Oaktree Specialty Lending made $243 million in new investment commitments in the second quarter, which was up from $104 million in the previous quarter. Still, due to investment exits and prepayments, Oaktree Specialty Lending's net new investments were negative for the second quarter in a row.
Approximately 90% of new investment commitments were First Liens, whereas 10% were Second Liens. With interest rates remaining high, thanks to the central bank's attempts to reign in inflation over the last year, passive income investors should not expect a return to growth in Oaktree Specialty Lending's origination business.
Oaktree Specialty Lending's Credit Quality And Dividend Coverage
When it comes to determining which BDCs to buy, hold, or sell, I tend to look at only two key metrics that give me a pretty good idea about whether a present dividend pay-out is at risk or not. The first ratio I look at is the non-accrual ratio, which measures the number of bad loans in a BDC's portfolio.
At the end of the second quarter, Oaktree Specialty Lending had five investments on non-accrual status which translate into a non-accrual ratio of 3.1% (based on fair value), meaning 3 more borrowers than in 2Q-23 experienced some level of financial stress and have fallen behind in terms of making payments. Oaktree Specialty Lending's non-accrual ratio was 2.4% (based on fair value) in 2Q-23.
In terms of the second point, dividend coverage, Oaktree Specialty Lending is still a very solid BDC, in my view. Oaktree Specialty Lending earned $0.62 per share in net investment income in 2Q-23, comfortable covering the pay-out of $0.55 per share. Despite the increase in second quarter non-accruals, the pay-out ratio has remained steady at 89%.
Discount To Net Asset Value Completely Disappeared
In the best-case scenario, I buy Oaktree Specialty Lending at a 10% or higher discount to net asset value in order to account for a margin of safety in my investment. Put simply, when BDC prices fall, I am a buyer, and I am a holder or seller if prices go up.
Presently, Oaktree Specialty Lending is selling at a 2% premium to net asset value, and I will consider selling at 1.1x NAV: This equates to a sell point of $21.54 (OCSL's NAV in 2Q-23 was $19.58).
When taking into account that OCSL has expanded its valuation (the BDC's net asset value discount has completely vanished) and that the BDC has seen a QoQ deterioration in credit quality, my new stock rating on OCSL is neutral.
Non-Accruals And Other Risks
Oaktree Specialty Lending's credit quality deteriorated in the second quarter, and the number of debt investments on non-accrual increased by three compared to the first quarter. This is concerning, particularly if the U.S. economy were to drift into a recession, in which case, an increase in loan defaults and non-accruals must be expected.
Taking into account that Oaktree Specialty Lending still covered its dividend with adjusted NII, I think investors don't yet have to worry about the BDC's dividend sustainability, just yet. A deterioration in credit quality and dividend coverage in the coming quarters, however, might result in a sell rating for OCSL.
My Conclusion
There is a time to buy BDCs like Oaktree Specialty Lending, which is when the stock is trading at a discount to net asset value. The time to scale back (and downgrade the stock) is when the gap between stock price and net asset value has narrowed or completely disappeared, as is the case here.
Buying a BDC at net asset value diminishes the margin of safety that is reflected in the BDC's valuation, particularly if portfolio quality has suffered.
Due to the change in portfolio quality in 2Q-23, my new stock rating is neutral/hold.
For further details see:
Oaktree Specialty Lending: Solid 11% Yield, But Don't Chase (Downgrade)