2023-03-09 04:44:33 ET
Summary
- Sixth Street maintained solid portfolio quality in the last quarter.
- The BDC covers its dividend with net investment income easily and has special dividend potential.
- TSLX deserves to trade at a higher premium net asset value.
Sixth Street Specialty Lending Inc. ( TSLX ) is a well-managed business development company with a portfolio that prioritizes safety. The BDC's portfolio is defensive, with an emphasis on secure First Lien debt instruments.
In the fourth quarter, the business development company covered its dividend with net investment income and maintained excellent portfolio quality, with a non-accrual ratio of 0% based on fair value.
The BDC's stock is currently trading at a 16% premium to net asset value, but I believe Sixth Street Specialty deserves a higher premium because the portfolio is extremely well-performing and the pay-out ratio is very low for the yield that TSLX provides passive income investors.
High Grade Portfolio Composition
I recommend TSLX to passive income investors, particularly those concerned about the performance of BDC assets during a recession. I mention this because I favor BDCs with strong balance sheets and defensively oriented debt investment structures, and Sixth Street Lending fits right in.
The business development company invested 90% of its assets in First Liens, the highest and safest form of debt in which BDCs can invest. The remaining 10% is allocated to second mortgages, unsecured debt, and equity investments.
Sixth Street Specialty's investment portfolio was valued at $2.79 billion at the end of 2022, with floating rate debt accounting for 98.9% of the portfolio. In a rising-rate environment, this debt generates higher interest income and serves as a lever for Sixth Street Specialty to increase its profitability in the future.
In the fourth quarter, Sixth Street Specialty made $212 million in new investments, 97% of those went to First Liens.
Portfolio Highlights - Asset Mix (Sixth Street Specialty Lending)
Higher interest rates have increased the cost of borrowing money in 2022, as evidenced by Sixth Street Specialty's portfolio yields. They experienced a significant increase in the latter half of 2022 as a result of the central bank's aggressive rate-hiking cycle.
Sixth Street Lending's weighted average interest rate on debt investments increased from 10.3% in 2Q-22 to 13.1% in 4Q-22 as a result of the BDC's aggressive floating rate positioning in its debt portfolio.
Portfolio Highlights - Net Interest Margin Analysis (Sixth Street Specialty Lending)
Sleep Well With TSLX's Covered And Raised Regular Dividend
Sixth Street Lending earned $0.64 per share in adjusted net investment income in the December quarter and paid a total dividend contribution of $0.45 per share, up $0.03 per share QoQ.
The fourth-quarter implied dividend pay-out ratio was only 70%, compared to a twelve-month dividend pay-out ratio of 83% (assuming only the base dividend pay-out) and 91% (assuming the base and variable dividend pay-out).
Sixth Street Lending pays variable dividends based on portfolio performance and special dividends to distribute excess income from the portfolio.
Sixth Street Lending has the potential to surprise passive income investors with special dividends in 2023 because the dividend is well-covered.
In February, the BDC declared a new $0.46 per share per quarter base dividend and a $0.09 per share supplemental dividend. TSLX has a stock yield of 9.6% based on its regular dividend payout.
Sixth Street Lending Is Deserving Of A Higher NAV Multiple
Considering the BDC's asset quality and strong credit performance, as evidenced by a 0% non-accrual ratio, I believe Sixth Street Lending deserves to trade at a higher premium.
The BDC's net asset value is currently valued at 1.16x, representing a 16% premium. TSLX has traded at twice the premium in the last year, and I believe it could trade at 1.20-1.30x NAV in the long run.
Why Sixth Street Specialty Lending Could See A Lower Valuation
Sixth Street Specialty is well-positioned for higher interest rates because it has invested 98.9% of its debt in floating rate loans.
If inflation falls and the Fed adopts a more dovish stance on rate hikes, the tailwinds from Sixth Street Lending's floating rate debt portfolio may not be realized.
Furthermore, because the BDC is fully performing, it no longer has a lever to improve the quality of its investment portfolio. Sixth Street Specialty may experience an increase in loan defaults and write-offs in the future, resulting in a discount valuation.
My Conclusion
Sixth Street Specialty has a lot of positive aspects. The portfolio has excellent credit quality, the pay-out ratio was only 70% in 4Q-22, making the dividend very secure, and the business development company continues to increase its base dividend pay-out.
Despite the fact that TSLX stock is no longer a bargain, I recommend TSLX to passive income investors who place a premium on the quality of a BDC's investment portfolio.
For further details see:
Sixth Street Specialty: Get A 9.6% Yield While You Sleep