FSCO: Big Downside Risk And Almost Certain Yield Cut (Downgrade)

In July this year, I published my first article on FS Credit Opportunities Fund (NYSE:FSCO). The thesis was bullish and based on conservative leverage, a high-quality portfolio, and a very competitive yield (again, despite the immaterial debt component). And by competitive, I mean FSCO's yield versus a typical level that we can lock in from BDC (BIZD) investments. At the moment when I issued the previous article, FSCO offered a yield of ~11.3%, which was almost exactly in line with the BDC sector average. You can find more details in the article about the reasons why FSCO is actually quite similar to BDCs, but the main ones are: 1) exposure to private credit loans, 2) mostly senior secured first-lien loans, 3) relatively modest exposure to equity-like products, and 4) presence of external leverage, which is important to magnify the positive spread effect from high-yielding investments and less expensive cost of capital.

What has happened since the release of my previous article is that both FSCO and BDCs have experienced a notable volatility.

Yet, the difference between BDC and FSCO performance is just massive.

On the one hand, we can now buy FSCO at a slightly better price level and still access ~11.5% yield. For example, FSCO trades at a discount of 1.8%, which is quite good given that the 52-week high was at 3.3%.

On the other hand, the BDC space, due to the recent pain, is now trading at a bargain basement level. For example, the sector median P/NAV is 0.81x - i.e., a discount of 19%. And here I am not talking about a sector median, which is constituted of speculative names. Morgan Stanley Direct Lending Fund (NYSE:MSDL) is a great example. It is a high-quality BDC with below-sector-average leverage, top-tier earnings quality (i.e., immaterial PIK), 90%+ of portfolio consisting of non-cyclical names, etc., and still the P/NAV is at 0.80x.

Given the above, my logical question is whether FSCO still is a buy. And I am looking at this from two angles: 1) FSCO as a stand-alone and yield-driven case, and 2) FSCO as a relative investment case in the context of very similar alternatives (i.e., BDCs).

Thesis review

Let's start with negatives first.

The First Brands bankruptcy has indeed sent shock waves across the private credit industry, which, apart from the interest rate factor, has, in my view, been one of the key reasons for the discounted pricing.

FSCO is among those private credit vehicles that have suffered from this particular event:

Luckily, FSCO's exposure to First Brands has been limited—less than 2% of the total asset base. But if we strip out First Brands from FSCO's loan book completely, then basically we arrive at price-to-NAV alignment.

So, I think that it would be fair to say that the First Brand aspect does not move the needle in terms of making a decision whether to invest or keep capital in FSCO.

However, the next topic is more critical, to say the least.

Based on the most recent financials, FSCO's dependency on PIK (payment-in-kind) proceeds is just massive. PIK accounts for almost 20% of the total income generation.

The situation gets worse if we measure PIK against what matters more - i.e., net investment income. The PIK/NII ratio is about 31%, which basically means that one-third of the income that FSCO receives comes in the form of a non-cash item or a promise that upon loan maturity FSCO will be able to convert all of these PIK proceeds into cash.

This is, obviously, a high-risk assumption, especially in the current market environment, where the economy is not in its best shape.

Speaking of interest rate risk, FSCO is exposed to the same problem as most BDCs. Namely, the lion's share of its asset base is linked to floating rates, which move in tandem with the base rates that the Fed has already cut by 25 bps this year and is likely to cut even more in the near-term.

It is more than clear that the direction of travel in the NII per share generation is unfavorable, and already in Q3, 2025, we should observe some decline (mostly interest rate driven, although we don't know what the net effects will be from the FV adjustments).

Now, the thing is that FSCO's yield of ~11.5% is already insufficiently covered by cash flows based on Q2, 2025 results. The NII per share (H1 basis) $0.36, while the distribution per share is $0.39.

In my view, a dividend cut here is simply inevitable.

Having said that, there is one huge positive that we have to appreciate. It is the debt side of the equation. Namely, as of Q2, 2025, FSCO had a net debt to equity of 0.30x, which is much lower than the BDC sector average of 1.19x. Even if we include the preferred shares, the debt to equity figure for FSCO looks very strong, at 0.47x.

So, I would say that the slight underfunding of the base dividend that I highlighted above is not only logical, but actually indicative of relatively solid situation. Think of it. The average BDC is leveraged at 1.19x, and the relevant BDC base dividend coverage level is 101%. With more than twice as high leverage, BDCs are operating with almost identical dividend coverage levels.

The bottom line

Relative to BDCs, FSCO's position is attractive. FSCO carries much lower debt and thus lower financial risk and/or stronger income growth potential that could come in handy in offsetting the forthcoming pressures from lower base rates and loan write-downs. At the same time, the difference between yield coverage with NII generation is not significant, certainly immaterial in the context of a way more equitized balance sheet.

At the same time, we should not ignore the PIK component, which has become a more significant risk zone considering the weakening economy and potentially more private credit-linked bankruptcies that might follow after First Brand. The fact that almost one-third of NII per share stems from PIK sounds scary now, when the general preference should be towards high margin of safety vehicles.

With this in mind, I have to downgrade FSCO and liquidate my position before it is too late. In my previous article - FSCO: Double-Digit Yield And Alpha Compared To BDCs, It's A Buy - I saw a clear alpha potential relative to BDCs. Looking at the very first chart in the article, we can see that the thesis has played out. Yet, my base case now is that we will in the near term see a similar correction in FSCO as most BDCs have experienced over the past couple of weeks, month.