FSCO: Strong Total Returns From Increased Private Credit Investments

A recent insight from Voya Investment Management suggests that rate cuts have been delayed in the second quarter of 2024 but not derailed. Many income investors like me are wondering if and how “higher for longer” rates will affect investments in credit funds that offer senior secured loans, corporate bonds, and related securities that generate high yield income.

Last month, we highlighted the silver lining for bond investors in this environment: For those worried they missed out on the opportunity to allocate to fixed income late last year (before the previous decline in rates), this recalibration in the market offers a second chance.

It’s also worth reminding investors that the changing whim of monetary policy is no longer the sole measuring stick for opportunities and risks. We have entered a new interest rate regime with real yields that are not only positive but also above their long-term historical average (Exhibit 1). This presents attractive carry opportunities and also leaves fixed income well positioned to deliver the broader portfolio ballast many investors expect. In other words, for the first time in 15 years, fixed income is a competitive asset class again.

When I first reviewed the FS Credit Opportunities fund (NYSE:FSCO) it was in September 2023 when I suggested, Use This Opportunity To Add Safe, High Yield Income To Your Retirement. At the time, FSCO had only been publicly traded for about 10 months, having just gone public in November 2022. This is how I summarized the opportunity at the time:

My assessment of FSCO is that the fund managers appear to have their pulse on the credit markets and with the ability to dynamically allocate between private and public credit investments, the fund is generating solid income that supports the high yield distribution. While the fund continues to trade at a substantial discount to NAV, which is rising, and with a recently increased monthly distribution, I rate FSCO a Buy for income-oriented investors who are looking for a relatively safe high-yield investment.

In the time since that article was published, FSCO has generated a total return of nearly 30%.

In February of this year I wrote an update on FSCO suggesting that investors can ride the corporate credit wave and collect a 12% yield along the way. At the time, the price of the fund was $5.67, and it still traded at a discount to NAV of about -18% while offering a monthly distribution of $0.0570, which worked out to an annual yield of about 12%. In the several months since that article was published, the price has shot up to $6.41 as of the market close on 6/10/24. The monthly dividend was also increased to $0.060 beginning in March (shortly after my article was published suggesting it was a Buy).

Today, FSCO trades at a narrower discount of about -10% and offers income investors a monthly distribution that amounts to an annual yield of about 11.2% going forward. This chart from CEFConnect shows how the discount to NAV has been steadily closing over the past year.

FSCO Overview and Recap of Q1 2024 Earnings

From the fund’s website, the Q1’24 quarterly update includes a fact sheet with some statistics about the fund and highlights from the Q1 2024 Earnings report. As of March 31, 2024, the fund held about $2.15B in total assets, making it one of the largest publicly traded credit-focused closed end funds.

The management team, which is part of FS Investments, took over control of the fund in 2018. The common shares of FSCO were listed on the NYSE in November 2022. The fund strategy and portfolio positioning are explained in the quarterly update:

Diversified credit strategy investing across public and private credit in loans, bonds, structured credit or highly structured equity investments and across fixed and floating rate assets.

The fund portfolio currently has about $2B in AUM focusing on senior secured debt.

With more than half of the investments in floating rate debt, the fund has benefited from the rising interest rate environment that we have experienced over the past 18 to 24 months. The portfolio positioning includes a dynamic allocation across public and private credit markets. With the strong recent returns from private credit, approximately 75% of new investments during Q1 were originated in private credit markets, as explained by Nick Heilbut, Director of Research and Portfolio Manager on the Q1 earnings call transcript:

Approximately 75% of new investment activity was in privately originated investments, and nearly all purchases were in first-lien secured loans. Public credit investments across first-lien and senior unsecured bonds represented approximately 25% purchases throughout the quarter.

The highlights from the first quarter are further detailed on the Q1 2024 quarterly report.

Advantages of the Fast-Growing Private Credit Market

According to a recent blog post from IMF, the Fast-Growing Private Credit Market Warrants Closer Watch.

The private credit market, in which specialized non-bank financial institutions such as investment funds lend to corporate borrowers, topped $2.1 trillion globally last year in assets and committed capital. About three-quarters of this was in the United States, where its market share is nearing that of syndicated loans and high-yield bonds.

Recently, some finance experts like Jamie Dimon of JP Morgan Chase (JPM) have cautioned about the increasing risk from private investments due to the rapid increase. Although there are risks there is still ample opportunity in private credit despite the headlines according to JPM.

With this record growth in mind, Dimon wasn’t completely pessimistic when discussing the private credit space. The CEO said there are distinct advantages to private lending, including the ability for private lenders to offer loan modifications and reasonable covenants that enable businesses to access cash quickly. The private credit space is also filled with mostly long-term investors, Dimon noted, which means they “aren’t going to be asking businesses to do stupid short-term things” in order to meet specific return obligations.

On the Q1 2024 earnings call, a question was asked during the Q&A about the substantial increase in private credit investments in FSCO. Head Portfolio Manager, Andrew Beckman addressed the question:

Q. I believe you said 75% of new investments during the quarter were in privately originated investments. Can you just talk about why this opportunity is attractive today?

A. … then when you flip into private credit, private credit is definitely more disciplined, from a dock perspective, and spreads are still higher in private credit. But the top part of the private credit market competes with the broadly syndicated loan market as sponsors are usually weighing what route to go down.

So as spreads have tightened and broadly syndicated credit and structural terms have loosened, traditional private credit has had to follow to some extent. You’re also seeing a lot of new entrants in traditional private credit, whether it’s kind of banks get into that market or different firms just raised lots of assets.

So for us, we’re trying to focus where others aren’t, where that capital is kind of not flowing and thus terms are more disciplined and are nontraditional areas of the private credit markets that we focus on, don’t really kind of price off the broadly syndicated market, don’t structure off of that and don’t really compete with those capital flows into private credit that I mentioned.

With about half of the fund now invested in public credit investments and half in private credit, the risk/reward equation has benefited shareholders who bought early with both an increase in the market price of the fund as well as an increased distribution. However, I feel that the party is not over yet for FSCO. When asked about the thought process for the recent dividend increase, this was Beckman’s response:

So, we were continuing to out earn our dividend. If you looked at our portfolio, we came into the year a little bit more cautious on rates, just looking kind of at the forward curve and how quickly rates were dropping. I think as everyone probably knows, Fed Funds expectations changed a little bit. So less rate cuts became priced into the market. We are continuing to out earn our dividend and we thought it was prudent to kind of pass on those excess earnings to investors.

Comparison with Peer Credit Funds

Other CEFs that also invest in fixed income credit and debt securities include several that have also performed well over the past year. In doing a brief comparison of total returns with several of those peer funds, including ARDC, KIO, JQC, and AIF (which is due to merge with MFIC), it is quite evident that FSCO is the clear winner with a total return of more than 55%.

Because FSCO does not have a very long history as a publicly traded fund, some investors may be hesitant to jump in after such strong performance. However, the discount remains rather wide at about -10% and the dividend yield is still tempting at around 11% with strong coverage. I rate the fund a Buy yet again, and especially if the market should suffer a correction and mark down the price to an even lower discount. I own shares of FSCO in my own Income Compounder portfolio.