FS Credit Opportunities Corp. (NYSE:FSCO) Q4 2024 Earnings Call Transcript March 1, 2024
FS Credit Opportunities Corp. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Robert Paun: Good morning, and thank you all for joining us for FS Credit Opportunities Corp’s Fourth Quarter and Full-Year 2023 Earnings Conference Call. Please note that FS Credit Opportunity Corps may be referred to as FSCO, the fund, or the company throughout the call. Today’s conference call is being recorded and an audio replay of the call will be available for 30 days. Replay information is included in a press release that FSCO issued on January 30th, 2024. In addition, FSCO has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended December 31, 2023. A link to today’s webcast and the presentation is available on the company’s webpage at www.fsinvestments.com under the FS Credit Opportunities Corp tab.
Please note that this call is the property of FSCO. Any unauthorized rebroadcast of this call in any form is strictly prohibited. Today’s conference call includes forward-looking statements with regard to future events, performance, or operations of FSCO. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ materially from those projected in these forward-looking statements. We ask that you refer to FSCO’s most recent filings with the SEC for important factors and risks that could cause actual results or outcomes to differ materially from these statements. FSCO does not undertake to update its forward-looking statements unless required to do so by law.
Additionally, information related to past performance, while helpful as an evaluative tool is not necessarily indicative of future results, the achievement of which cannot be assured. Investors should not view the past performance of FSCO or information about the market as indicative of FSCO’s future results. Speaking on today’s call will be Andrew Beckman, head of FS Global Credit and Portfolio Manager for FSCO; Nick Heilbut, Director of Research of FS Global Credit and Portfolio Manager for FSCO. Also joining us on the phone is James Beach, Chief Operating Officer of the Fund. Following our prepared remarks, the team will take questions from the audience. If you’d like to ask a question, there is a chat function on the right side of your screen.
You will try to address each of your questions after our prepared remarks. I will now turn the call over to Andrew.
Andrew Beckman: Thank you, Robert, and good morning, everyone. Looking back on 2023, we are proud of the results we delivered for our shareholders across several key fronts. First, we delivered strong returns in 2023, as the fund returned 20.1% on a net basis, outperforming the ideal bond and senior secured loan indices by 667 basis points and 707 basis points, respectively. This performance was strong on an absolute and relative basis as FSCO outperformed many of the larger credit-focused peers in the closed-end fund space. Net investment income fully covered distributions of $0.64 per share, and the fund’s net asset value increased by $0.59 per share, or 9.3% year-over-year. We believe our performance reflects the dynamic nature of our strategy, investing across public and private credit with a focus on generating return premiums driven by the complexity of a company’s balance sheet, the illiquidity of an asset, unconventional ownership, or corporate events.
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Q&A Session
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We increased the funds annualized distribution by 15% in July, driven by rising market yields and the continued strong performance of our investment portfolio. This was the second increase in the annualized distribution since the fund’s common shares listed on the New York Stock Exchange in November of 2022. Finally, we completed all phases of FSCO’s listing on May 15, 2023, and marked the one-year anniversary of the listing on the NYSE in November of last year. The discount at which the fund’s common shares traded relative to its net asset value narrowed significantly during the year. We believe the improvement reflects the fund’s strong performance, broader market strength, and reduced selling pressure on the stock after all the phases of the listing were completed.
While we are pleased that FSCO shareholders earned a total return of nearly 35% for the year, we believe the current discount at which the stock is trading compared to NAV does not reflect the health of the portfolio or the high quality of our investment program. During the fourth quarter, fund paid monthly distributions totaling $0.17 per share, which were fully funded through net investment income, as has been the case since the FS Global Credit Team assumed management of FSCO in January of 2018. As of February 28, 2024, the fund’s annualized distribution yield was 9.8% based on NAV and approximately 12.17% based on the stock price. In terms of portfolio performance, contributors far outpaced attractors as positive performance was broad-based across the portfolio in 2023.
The largest contributor performance during the fourth quarter and year resulted from unrealized appreciation in New Giving, Inc., one of the fund’s largest holdings, a directly originated investment in a healthcare services firm. The company produced strong revenue and earnings growth as operational measures implemented in 2022 continue to positively impact the business throughout 2023. This investment highlights our ability to source differentiated opportunities and creatively structure the investments. FSCO received common equity and warrants as part of our debt investment, which provides for the potential for meaningful additional capital appreciation, yet preserving the downside protection we like to see in our investments. Opportunistic equity hedges detracted from the funds returned during the year amid the strong environment for equities.
I will now turn the call over to Nick to provide our perspective on the markets and discuss our investment activity during the fourth quarter.
Nick Heilbut: Thanks, Andrew. Risk assets rallied during the fourth quarter as expectations for an economic soft landing supplanted recession fears. Treasury yields plunged during the quarter with two-year and 10-year yields falling approximately 80 basis points and 70 basis points, respectively, as investors firm their expectations for Fed rate cuts in the first half of 2024. Amid falling yields, the Bloomberg US Aggregate Index returned 6.82% in the fourth quarter in a generally strong environment for longer duration fixed income assets. Positive investor sentiment and a supportive technical backdrop through high yield bond spreads to their lowest point since January 2022 while loan spreads reached their lowest point since May 2022.
High yield bonds returned 7.1% during the quarter outperforming senior secured loans which returned 2.9%. Returns by credit rating were generally mixed during the quarter as lower rated credit flat performance. The CCC bonds returned 20.4%, outpacing BB bonds by 892 basis points. CCC rated loans returned 17.5% compared to 10.2% for BB loans. Although the technical environment supported credit prices, driven by strong investor demand and reduced supply, fundamental backdrop deteriorated modestly during the year as evidenced by a uptick in default and lower recovery rates. The high yield default rate, including distressed exchanges, increased to 2.88% as of December 31, 2023, while loan defaults and distressed exchanges rose to 3.08%. This compares to default rates of 1.65% for high-yield bonds and 1.59% for loans as of December 31st, 2022.
Meanwhile, recovery rates took a net worthy decline, hitting 38% for loans, a record low, and 33% for bonds, which was not a record low, but far below high yield bonds, long-term average recovery rate of 40%. Turning to investment activity, the fund remained fully invested throughout the fourth quarter, driven by a healthy pipeline of new investments and relatively low levels of repayments, excluding portfolio hedges, purchases of $184 million, exceeded sales, exits, and repayments of $173 million. Demand for high-yield bonds and senior secured loans were amid improved investor sentiment, while new issuance was limited by sluggish M&A environment. In today’s competitive markets, we continue to leverage the insights and deal flow across FS Investments’ $28 billion credit franchise, while using our deep relationships with company management teams, commercial investment banks, financial sponsors, non-bank intermediaries, and other private credit managers drive a steady pipeline of investments in public and private credit.
Approximately 63% of new investment activity was in privately originated investments during the quarter, comprised entirely of first lien senior secured loans. Public credit investments, which represented 37% of purchases during the quarter, were comprised also almost entirely by first lien loans as well as high-dose bonds. As of December 31, 2023, approximately 81% of the portfolio consisted of secured debt, up from 77% the previous quarter. The fund’s allocation to subordinated debt was 5%, down from 7% in the previous quarter. Asset based finance represented 4% of the portfolio, unchanged from the previous quarter, while equity and other investments represented 10% compared to 12% as of Q3 2020. Public credit represented approximately 53% of the portfolio, while private credit comprised approximately 47% as of the end of the year.
Excluding asset-based finance investments, the largest sector ratings at quarter-and were consumer services, followed by healthcare equipment and services, and commercial and professional services. We believe these investments offer the potential to drive strong risk-adjusted returns and operate in areas of the economy that may be more insulated in the event of a broader economic slowdown. Turning to the liability side of our balance sheet, we believe our cost structure gives us a competitive edge with 43% of drawn leverage comprised of preferred debt financings that provide payable regulatory treatment versus traditional term loans or revolving debt facilities. Approximately 43% of drawn leverage is multi-year fixed rate preferred debt and provides flexibility in the types of assets we can borrow against.
