OFS Credit's NAV Rises Amid High Yields: Can the Good Times Last?

The May 2025 update from OFS Credit Company (NASDAQ: OCCI) reveals a slight uptick in its net asset value (NAV) to between $6.23 and $6.33 per share, marking a modest improvement over April's $6.17. While this signals short-term resilience, the question remains: Can the company sustain its headline-grabbing 20.7% annualized distribution yield amid rising macroeconomic headwinds and the inherent risks of its CLO-heavy portfolio? Let's dive into the numbers and the risks.

The Numbers: A Tightrope Walk Between Yield and Sustainability

First, the positives:
- OFS Credit's Core Net Investment Income (Core NII) for the quarter ended April 30, 2025, hit $9.2 million, or $0.37 per share. Annualized, this equates to $1.48 per share, comfortably covering the $1.38 annualized distributions ($0.115/month).
- The weighted-average effective yield of its investment portfolio rose to 14.07%, driven by a staggering 20.04% yield from its CLO equity investments.

But there's a catch. The company's NAV estimate is preliminary, and distributions may include return of capital—a red flag for sustainability. The final tax character of these payments won't be known until year-end, raising questions about whether the yield is eating into principal or truly derived from income.

The Portfolio: CLOs as a Double-Edged Sword

OFS Credit's outperformance hinges on its collateralized loan obligation (CLO) equity investments, which delivered the 20.04% yield. CLOs pool risky corporate loans and slice them into tranches, with equity tranches offering high returns for accepting maximum risk. While this strategy has paid off in a rising-rate environment, it's deeply sensitive to economic downturns.

If recession fears materialize—or if the Russia-Ukraine war escalates, destabilizing global credit markets—the value of these CLOs could plummet. This would hit both NAV and Core NII, potentially forcing a distribution cut.

Capital Raising and the DRIP: Buying Time or Buying Trouble?

In the second quarter, OFS Credit raised $40.4 million through stock issuances, including an At-the-Market offering and a private placement of preferred stock. This capital influx could help fund distributions and buffer against NAV volatility. Meanwhile, its Dividend Reinvestment Plan (DRIP) offers participants a 5% discount on shares, which might attract income-seeking investors.

However, constant equity issuance dilutes existing shareholders and could pressure the stock price if perceived as a sign of financial strain. Investors should monitor dilution metrics and the cost of capital for these issuances.

The Risks: A Volatile Dance with the Fed and Geopolitics

• Interest Rates: The Federal Reserve's stance on rates remains uncertain. Higher rates could boost CLO cash flows (as loans reset to higher rates) but also increase borrowing costs for underlying corporate borrowers, risking defaults. Historical evidence underscores this fragility: a backtest of buying OCCI one day before Fed rate decisions from 2020 to 2025 and holding for 30 trading days yielded an average return of just 1.32%, with a maximum drawdown of -47.21% and volatility of 32.18%. This strategy's poor Sharpe ratio of 0.01 highlights its risk-inefficient nature.
• Geopolitical Tensions: The Russia-Ukraine war and its ripple effects on energy markets and global inflation are unpredictable variables.
• Distribution Sustainability: If the NAV slips further, the yield could erode, especially if the market price declines. The current yield of 20.7% assumes a $6.67 share price—any drop would require a proportional increase in distributions to maintain it.

Investment Takeaway: A High-Reward, High-Risk Proposition

OFS Credit's May update paints a picture of a company leveraging its CLO expertise to deliver outsized returns. For income-focused investors with a high-risk tolerance, the 20.7% yield is tempting, especially if they believe in the resilience of CLO equity in a moderately rising-rate environment. The DRIP's 5% discount adds a tactical advantage for long-term holders.

But caution is critical:
- Avoid over-allocating: This is a speculative play. Limit exposure to a small portion of your portfolio.
- Monitor NAV trends: A sustained drop below $6.20 could signal trouble.
- Watch for return of capital: If distributions increasingly rely on principal, exit.

In short, OFS Credit's high yield is a short-term gift, but its sustainability hinges on factors beyond its control. Investors should treat it as a high-octane, high-volatility opportunity—not a core holding.