FS Credit Opportunities Corp.

Good morning and thank you all for joining us for FS Credit Opportunity Corp's first quarter 2024 earnings conference call. Please note that FS Credit Opportunities Corp may be referred to as FSTO, 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 FSTO issued on April 22nd, 2024. In addition, FSEO has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended March 31st, 2024. A link to today's webcast and the presentation is available on the company's webpage at www.fsinvestments.com. 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 FSTO'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. FSTO 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 FSEO or information about the market as indicative of FSEO's future results. Speaking on today's call is Andrew Beckman, head of FS Global Credit and portfolio manager for FSEO, and Nick Helbit, Director of Research of FS Global Credit and Portfolio Manager for FSBO. Also joining us on the phone is James Beach, Chief Operating Officer of the Fund. Following our prepared remarks, we will take questions from the audience. If you'd like to submit your question, please use the Q&A function on the right side of your screen, and we will strive to answer as many questions as possible. In addition, I'd like to point out the resources that we have listed at the bottom of the screen, which you can access throughout the call, including a link to the earnings presentation. I will now turn the call over to Andrew.

Thank you, Robert, and good morning, everyone. We are proud of the results we delivered for our shareholders during the first quarter of 2024 across several key fronts. First, the fund delivered a net return of 5.8% based on NAV and outperformed the high yield bond and senior secured loan indices by 429 basis points and 338 basis points respectively during the quarter. This performance was strong on an absolute and relative basis as FFCO outperformed many of the larger credit focused peers in the closed end fund space. As has been the case since the FS Global Credit team assumed management of FSEO in January of 2018, net investment income fully covered distributions paid during the quarter. 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. Next, we are pleased to continue to reward shareholders by increasing the fund's monthly distribution to $0.06 per share in connection with the March distribution, which represented a 5% increase over the February distribution. The increase was driven by the continued strong performance of our investment portfolio. This was the third increase in the distribution since the fund's common shares listed on the New York Stock Exchange in November of 2022. The fund paid a total of 17 cents per share of distributions in the first quarter. As of May 16, 2024, the fund's annualized distribution yield was 10.12% based on NAV, and approximately 11.71 percent based on the stock price. Finally, the discount at which the fund's common shares traded relative to its net asset value narrowed significantly in 2023, and that trend has continued into the start of 2024. We believe the improvement reflects the fund's continued strong performance, the increase in the annualized distribution in March, and the broader strength in the credit markets. While we are pleased that FSEO shareholders earned a total return of 7.8% in the first quarter of 2024, we believe the current discount at which the stock is trading compared to the NAV still does not reflect the health of the portfolio or the high quality of our investment program. Turning to the fund's performance, The fund's net asset value increased by 22 cents per share. Portfolio performance was broad-based during the quarter. The largest individual contributor was New Giving, a directly originated investment in a healthcare company. This investment highlights our ability to source off-the-run opportunities and creatively structure investments. FFCO received common equity and warrants as part of our debt investment, which provides the potential for meaningful additional capital appreciation. This was a non-sponsor transaction that we sourced through our proprietary network. I'll now turn the call over to Nick to provide our perspective on the markets and discuss our investment activity during the first quarter. Thanks, Andrew. The start of 2024 has seen a continuation of the positive investor sentiment that ended 2023. Resilient corporate earnings, a positive growth outlook, and a healthy labor market have underpinned valuations, even as markets have needed to absorb a higher resting heart rate for interest rates and inflation. Treasury yields rose during the quarter as the 10-year yield increased 33 basis points to 4.2%. While the policy-sensitive two-year yield increased 37 basis points to 4.62% as investors reduced their expectations for the number of rate cuts the Federal Reserve would enact in 2024. Spreads on high-yield bonds and senior secured loans tightened to their lowest levels since April 2022. Senior secured loans returned 2.38% during the quarter, benefiting from the elevated rate environment as investors delayed their expectations for Fed rate cuts, while high-yield bonds returned 1.47%. Lower-rated securities again led returns during the first quarter, in line with the performance trend throughout 2023. CCC loans returned 5.17%, outpacing BB loans by 317 basis points. while CCC-rated bonds outpaced BB bonds by 211 basis points. Following two consecutive years of leveraged credit market shrinking, high-yield bond and loan issuance surged in the first quarter compared to recent quarters. As of March 31st, year-to-date loan issuance represents 86% of the total volumes in 2023, while high-yield issuance stands at 65%. Notably, repricings comprised 48% of gross loan issuance, a post-GFC high. Fundamentals remain generally firm in the high-yield market, where strong economic growth has supported revenue and EBITDA, the latter of which grew 4.6% year-over-year as of the end of 2023. Leverage remains low and coverage strong versus long-term averages. Default rates are in line with the 25-year averages for high-yielding loans. While we don't expect these levels to rise materially through year-end, the high-yield default rate may be more subdued given healthier fundamentals. Double Bs comprise 46% of the index and triple Cs just 13% compared to long-term averages of 40 and 18, respectively. Conversely, approximately 29% of the loan market is rated B- or lower. an all-time high that we believe deserves attention in an environment where recovery rates have persistently declined. Turning to investment activity, the fund remained fully invested throughout the first quarter. Purchases, excluding portfolio hedges, totaled approximately $155 million, compared to sales, exits, and repayments of $122 million. Credit markets remained competitive during the quarter. Especially in these times, we continue to leverage the insights and deal flow across F Investments' $79 billion asset management program platform and use our deep relationships with commercial and investment banks, non-bank intermediaries, sponsors, industry specialists, and other like-minded investment firms to drive a steady pipeline of investments in public and private credit. 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. As of March 31st, approximately 81% of the portfolio consisted of senior secured debt, unchanged from the previous quarter. Funds allocation to subordinated debt was 5%, also unchanged. Asset-based finance represented 4%, while equity and other investments represented 10%. Public credit represented approximately 43% of the portfolio, while private credit comprised approximately 47%. Excluding asset-based finance investments, the largest sector weightings at quarter end 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 broad economic slowdown. Turning to the liability side of our balance sheet, we believe our cost structure gives us a competitive edge, with 42% of drawn leverage comprised of preferred debt financings provide favorable regulatory treatment versus traditional term or revolving debt facilities and flexibility in the types of assets we can borrow against. Approximately 42% of drawn leverage was multi-year fixed rate preferred debt as of March 31st. On May 16th, the fund issued $100 million of term preferred shares due in May 2029 at 205 basis points over Treasury's. Preferred financing provides the fund with additional purchasing power at favorable pricing. As of March 31st, the fund's cash balance was approximately $92 million, and we have ample availability in our credit facilities. I'll now turn it back to Andrew to discuss our forward outlook. Thanks, Nick. The momentum carrying the economy through the most aggressive rate hike cycle in decades continued in the first quarter, supporting the performance of risk assets. Against this backdrop, however, challenges linger. Inflation is persistently above the Fed's 2% target. Regional conflicts continue and geopolitical risks remain elevated. Recognizing the uncertainty, we've constructed the portfolio based on several key attributes. First, We believe active management combined with sound fundamental credit underwriting will remain critical to driving returns and avoiding losses in the year ahead. We're focused on businesses with strong cash flows, modest leverage profiles, and management teams with deep operational experience managing through market cycles. We're invested in credits with appropriate loan-to-values to ensure ultimate repayment of the obligations to the extent we were to see an economic slowdown. Our sector allocations are informed by our bottoms-up fundamental research, and we tend to avoid highly cyclical areas of the economy unless LTVs are particularly low. Credit spreads are tight, and covenants in the broadly syndicated loan market are weak. This coupled with uncertainty over inflation, rates, and the durability of the economy are causing us to be a bit more cautious now about making new investments than we would be in other environments. Therefore, we are maintaining some extra buying power to minimize potential drawdowns but also take advantage of investment opportunities should a period of volatility arise. We continue to focus on senior debt investments with strong terms and attractive yields or expected total returns. We generally avoid debt in private equity-owned companies where we think there could be a material risk of leakage due to covenants or disputes with lenders. We are also cautious on credits where there are significant EBITDA add-backs that may never materialize and instead are focusing on free cash flow. We seek to identify situations where return premiums exist due to the complexity of a company's balance sheet, the illiquidity of an asset, unconventional ownership, or as a result of corporate events. Third, we will continue to leverage size and scale to drive differentiated outcomes for our investors. FFCO is one of the largest credit-focused end funds in the market, with $2.15 billion in assets as of March 31, 2024. Size and scale matter in credit investing, especially when it comes to maximizing deal flow. The portfolio management team also leverages the full resources, infrastructure, and expertise of FS Investments, $76 billion alternative asset manager. As Nick discussed, we believe our leverage structure provides FSEO with a unique advantage as a large percentage of our drawn leverage is multi-year, fixed rate, preferred debt, and provides flexibility in the types of assets we can borrow against. Finally, our ability to invest across public and private markets differentiates us from traditional credit closed-end funds and allows us to adjust allocations based on where we believe the best risk-adjusted return opportunities lie. Our goal is to dynamically allocate capital to the most attractive opportunities across the credit and business cycle, and we think this leads to enhanced stockholder returns relative to a more confined strategy. Importantly, we are not constrained by specific asset class mandate. We can invest across loans, bonds, structured credit, and highly structured equity investments, and across fixed and floating rate assets. Our private investment portfolio includes highly bespoke investments originated through our team and our firm-wide sourcing network. our intensive due diligence process benefits from the sharing of collective insights on markets and individual credits. We believe our origination capabilities within the private market and focus on providing specialized financing solutions differentiates us from our closed-end fund peer group. In summary, we believe FSTO is a compelling long-term investment opportunity based on our well-positioned portfolio low average duration, healthy distribution, diversified capital structure, and the flexibility of our strategy. We believe we have a fund and platform built to drive strong risk-adjusted return for a diverse range of economic and financial markets. Since the investment team assumed portfolio management responsibilities in January of 2018, the fund on a net basis has outperformed the gross returns of high-yield bonds by 319 basis points and loans by 212 basis points. The team has invested more than $7 billion over the last six years in non-traditional areas of the credit market, including opportunistic and adventurous credit, dislocated special situations, and private structured capital solutions. Once again, Thank you all for joining us today. And with that, we'll take a brief pause to review the queue before answering your questions.

Just as a reminder, if you'd like to submit a question, please use the Q&A chat function on the right side of your screen. Okay, our first question, I believe you mentioned spread tightening in your prepared remarks. Can you please provide some more color on what you're seeing in the market today as far as pricing and spread levels and how that compares to six months to a year ago?