FS Credit Opportunities Corp. (FSCO) recently reported a strong first quarter of 2024, boasting a 5.8% net return on NAV and outperforming both high-yield bond and senior secured loan indices. The company also announced its third distribution increase since its NYSE listing in November 2022. While seemingly positive, a closer look at the earnings call transcript unveils a subtle shift in tone and language, suggesting a potential dividend cut might be on the horizon.

Cautious Tone Raises Eyebrows

Throughout the call, FSCO's management team, especially Andrew Beckman (Head Portfolio Manager), emphasized a cautious economic outlook. While acknowledging the current economic strength, they highlighted concerns about inflation, interest rates, and a slowdown in manufacturing and consumer spending. This cautious tone contrasts sharply with the prevailing market optimism, which anticipates an economic soft landing and potential rate cuts soon.

Dividend Strategy: Reading Between the Lines

The most telling sign emerged during a discussion about the dividend strategy. When questioned about potential dividend changes, Beckman's response was carefully crafted. While affirming that the dividend is "more than covered" with "cushion in the near term," he added a crucial caveat: "We are facing a downward sloping yield curve."

This statement is significant for two reasons:

A downward sloping yield curve often foreshadows an economic slowdown or even a recession. It implies investors have lowered expectations for future economic growth and inflation.

FSCO's dividend coverage relies heavily on its net interest income, which benefits from a steeper yield curve. A flattening yield curve narrows the spread between borrowing and lending rates, potentially squeezing their net interest income and their ability to maintain the current dividend level.

Numbers Paint a Compelling Picture

Let's examine the financials. In 2023, FSCO's net interest income was $196.5 million, up from $184.6 million in 2022, mainly driven by higher interest rates and a wider spread. However, with a flatter yield curve expected in 2024, sustaining this net interest income level could be challenging, particularly if the Federal Reserve continues to raise interest rates as anticipated.

Source: SEC Filings

Private Investments: A Double-Edged Sword

Adding to the intrigue is FSCO's growing focus on privately originated investments, which accounted for 75% of their new investments in Q1 2024. While offering potentially better spreads and terms compared to tighter public markets, these private deals also come with less liquidity. This strategic shift, while potentially lucrative in the long run, could limit FSCO's ability to quickly adapt its portfolio to sudden market shifts or generate immediate cash flow to support the dividend if needed.

New Preferred Shares Add to Interest Expense

Furthermore, FSCO's recent issuance of $100 million in term preferred shares, while providing additional capital, also increases their overall interest expense. While intended to boost their purchasing power, this move could further strain their net interest income, particularly if the yield curve flattens significantly.

Investor Takeaways

Investors should closely monitor FSCO's upcoming earnings calls for any further signs of a potential dividend cut. Pay attention to management's commentary on:

Interest rate outlook

Yield curve expectations

Net interest income projections

Additionally, scrutinize their investment activity, especially their allocation to private versus public credit, as this could signal their confidence in the broader market and their ability to generate enough cash flow to sustain the current dividend level.

"FSCO Fun Fact"

Despite its recent listing in 2022, FSCO has a longer history. It was originally launched as a non-traded BDC in 2013, meaning it didn't initially trade on a public stock exchange. This transition to a publicly traded company provides investors with greater liquidity but also subjects FSCO to increased market scrutiny and volatility.