We recently started a series of reports on how income investors can boost their income by investing in collateralized loan obligations (or CLOs). In the first report of this series, we explained what CLOs are and how they function. If you did not get a chance to read the report, this is the link:
In our second report of the same series, we highlighted our favorite CLO investment which is Oxford Lane Capital (OXLC). This report was also published recently on Seeking Alpha and entitled: 16% Yield From A Great Financial Crisis Tested Asset Class, By Oxford Lane
Today's article is the third of this series whereby we highlight Saratoga Investment (SAR), a BDC that manages CLOs.
SAR is a very unique because this is a dividend growth BDC. Note that the vast majority of BDCs do not grow their dividends. We are particularly bullish on SAR which recently hiked its dividend again to $0.54 a share for a forward yield of 8.9%.
SAR manages CLOs and therefore is lower risk than OXLC or Eagle Point Credit Company (ECC) which invest mostly in CLOs. Both myself and co-author Treading Softly are long OXLC, ECC and SAR in this sector.
Brief Company Overview
SAR is a BDC and CLO manager that is rapidly growing its assets under management (AUM). SAR will continue to see positive market price action due to its recent note offering, adding additional funding means at a low cost. SAR is a high-yield stock that currently yields 8.9%. As a BDC, the dividends are subject to 1099 taxation, so investors do not receive K-1 tax forms, which is a great advantage.
SAR operates as a BDC and makes investments in middle market companies - either through loans or direct investment - to seek its income. SAR has also started and managed a CLO. These two main avenues provide SAR's income.
SAR has actively increased its focus on BDC lending versus being heavily dependent on its one CLO. Last year, SAR upsized its CLO to $500 million. This is an increase of $200 million or almost doubling the CLO size. SAR oversees the CLO and receives management fees to ensure the loans inside of the CLO are within their credit ratings and performing properly. This increase was perfectly timed for when the senior leveraged loan market saw massive price decreases. As a CLO manager, it oversees adding those loans to its CLO - making every dollar invested to turn around and earn higher returns for its tranche holders.
Source: SAR Earning Slides
SAR's portfolio is comprised primarily of first and second lien loans. These provide stability to SAR's portfolio, and its overall yield support continued issuance of shares at 9% to see a return of 10%.
To also help fund growth, SAR recently offered an additional $40 million worth of notes due in 2025. These notes yield 6.25%, vastly less than their portfolio returns and trade under the name and ticker Saratoga Investment Corp. 6.25% (SAF). This will help the fund continue its net investment income growth at a lower cost than issuing additional shares.
Strong Historic Growth
SAR's management has overseen strong AUM and NAV growth for its investors - meanwhile keeping net investment income high.
Source: SAR Earning Slides
SAR's AUM has risen 455% since 2011. This would be a sign of concern for investors, meaning SAR has diluted its shares or rapidly stacked on debt for growth. However, this massive increase in AUM - typically a 13% quarter-over-quarter change - corresponds with the steady improvement of SAR's credit strength in regards to its underlying assets. Only two loans in the last report were considered non-accrual. How has this rapid growth in AUM reflected for shareholders of SAR? Rapidly growing NAV.
Source: SAR Earning Slides
SAR's NAV has seen strong growth. This NAV is a fundamental part of its strategy. A growing NAV raises the question of how profitable this NAV growth has been. The answer is strong.
Source: SAR Earning Slides
SAR's net investment income, essentially what is left of its income after expenses are deducted, has seen strong growth. This growth translated into a growing dividend, which we'll discuss next. This strongly reveals that SAR's efforts to grow have not come at the expense of shareholders, but to their direct benefit. SAR's growing size has enabled it to access lower cost capital than issuing shares as seen with the recent note offering. Those notes cost less than issuing the equal dollar amount of shares, which in turn will bolster the growth of SAR's NII. We strongly expect SAR's NII to continue to rise as it grows and conservatively maintains a strong, credit-focused portfolio.
SAR's dividend is issued on a quarterly basis, and it has seen steady, strong growth. The dividend was hiked for 17 straight quarters. This is very remarkable!
Source: SAR Earnings Slides
Even more remarkable is that the dividend hikes have been steep, and they have risen by 194% since Q2 2015.
Currently, SAR is actively over-earning its dividends by 23%, which means there are more hikes on the way. This also provides SAR with additional powder to complete accretive deals. SAR's management forecasts that additional dividend increases are coming.
SAR's high 8.9% yield and continued growth warrant a possible future investment since this company will readily reach 10% on today's prices after continued increases. However, SAR continues to climb towards its previous Sept. 2018 prices.
Data by YCharts
Another reason an investment in SAR would benefit immediate income seekers is that it consistently has a high yield while seeing capital appreciation or preservation. SAR's quiet winner status has provided a continued opening for investment to capture this high yield.
SAR is at a fantastic point of its growth. The market yield is well below its portfolio yield, and the recent issuance of notes provides it an inexpensive means of additional funds versus at-the-market issuance of shares. SAR's management has a fantastic track record of growth in conservative means. 99% of its investments are considered to have a strong credit rating by SAR's management.
The main risk facing SAR is the floating nature of its loan portfolio; as the prime rate is expected to remain steady, or face a cut later this year, SAR's income will decrease, too. This concern, however, is mitigated by SAR's use of a 3-month LIBOR and a set rate - generally between 6% and 8%, and sometimes as high as 9.75%. This means even small prime rate changes will not impact SAR's ability to grow as strongly as others.
SAR's exposure to CLOs is limited when compared to peers like Oxford Square Capital (OXSQ) or Prospect Capital (PSEC). This is to investors' benefit. Typically a BDC that is too much invested in CLO debt or equity tranches is exposed to greater risks than a fund like Eagle Point or Oxford Lane that are designed to mitigate CLO risks. BDCs are limited to the amount of CLO exposure that they can have. SAR manages its CLO and only holds a limited amount of the equity tranche, which was required at the time it issued it. This provides the management income with limited NAV fluctuations from the CLO tranche value changes.
An investment in SAR has multiple benefits:
- A growing high yield
- Strong credit strength of obligators
- Rapidly growing AUM that is over-earning its yield
This company has a bright future, conservative management and a growing yield in the mix. Investors should consider adding this into their mix of BDC investments. We consider SAR a buy below $25.00 as its growing yield and conservative nature will bring its yield higher over time.
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Disclosure: I am/we are long SAR, ECC, OXLC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.