Oxford Square Capital: High-Yield BDC Navigating Rising Rates with Strategic Income Potential

In a world where central banks are tightening monetary policy to combat inflation, income-focused investors are increasingly turning to high-yield business development companies (BDCs) as a strategic play. Among these, Oxford Square Capital Corp. (OXSQ) stands out for its aggressive dividend yield and evolving portfolio structure. However, its financial metrics and market positioning reveal a complex picture of opportunity and risk in a rising rate environment.

The Allure of High-Yield BDCs

BDCs like OXSQ thrive in environments where interest rates are climbing. By leveraging debt to invest in high-yield assets—such as senior secured loans and collateralized loan obligations (CLOs)—they can generate attractive returns for income-seeking investors. OXSQ's 18.25% dividend yield as of August 2025 is among the highest in the BDC sector, driven by its $0.42 annualized dividend per share and a stock price of $2.30. This yield is particularly compelling in a world where traditional fixed-income assets are yielding less than 5%.

Yet, the sustainability of this payout is questionable. OXSQ's trailing twelve-month net investment income (NII) per share is -$0.01, meaning the dividend currently exceeds earnings. This gap raises concerns about the company's ability to maintain distributions during periods of economic stress or declining portfolio performance.

Portfolio Strategy: Secured Debt as a Hedge

OXSQ's Q2 2025 portfolio highlights a defensive shift toward first-lien secured debt, which now accounts for 49.8% of the portfolio by fair value, up from 34% in Q2 2024. This move prioritizes assets with stronger collateral and repayment priority, offering downside protection in a rising rate environment. Conversely, exposure to riskier second-lien secured debt has dropped to 11.0% from 31% a year ago.

The company's focus on CLO equity investments (37% of the portfolio) also aligns with its income strategy. While CLOs are typically floating-rate instruments, their yields have declined to 8.8% in Q2 2025 from 9.6% a year ago. This trend reflects broader market pressures, including higher interest rates and tighter credit spreads. Nonetheless, CLOs remain a cornerstone of OXSQ's income generation, contributing $3.9 million in interest income during the quarter.

Leverage and Capital Structure: A Double-Edged Sword

OXSQ's leverage profile has improved, with a debt-to-equity ratio of 0.73x as of June 30, 2025, down from 0.84x in the prior quarter. This reduction in leverage provides flexibility to navigate rising interest rates, as the company's debt includes long-dated, fixed-rate notes (e.g., $34.8 million due in 2026 at 6.25% and $80.5 million due in 2028 at 5.50%). A recent $65 million issuance of 7.75% notes due 2030 further extends the maturity profile and reduces refinancing risks.

However, OXSQ's expense ratio remains a drag. The base management fee of 2% plus a 20% net investment income (NII) incentive fee creates a cost structure that erodes returns, especially when NII is negative. Total expenses for Q2 2025 were $4.0 million, with fees on non-cash income and management fees on cash holdings compounding the challenge.

Risks and Rewards in a Rising Rate Environment

OXSQ's strategic reallocation to secured debt and CLOs enhances its resilience to rising rates, but its declining net asset value (NAV)—now $2.06 per share, down 13.64% year-to-date—poses a significant headwind. The NAV decline is driven by weak net investment income and a 10.49% drop in share price during Q2 2025. While the company raised $11.6 million via an at-the-market offering, this capital infusion has not reversed the downward trend.

The company's floating-rate exposure is another critical factor. While OXSQ's portfolio includes leveraged loans and CLOs (typically floating-rate), the exact proportion of floating-rate debt is not explicitly stated. However, the weighted average yield of debt investments at 14.5% suggests a meaningful portion of the portfolio benefits from rising rates. This could help offset the drag from fixed-rate debt and declining CLO yields.

Investment Thesis: Balancing Income and Risk

For income investors, OXSQ's 18.25% yield is undeniably attractive. However, the company's financial metrics—negative NII, declining NAV, and high expense ratio—highlight structural challenges. The strategic shift to secured debt and CLOs provides some insulation against rising rates, but the sustainability of the dividend remains a key concern.

Investment advice:
1. Diversify exposure: OXSQ should be a small part of a broader high-yield BDC portfolio to mitigate concentration risk.
2. Monitor NII trends: Watch for signs of stabilization in net investment income, which would signal improved earnings coverage of the dividend.
3. Assess leverage discipline: The company's reduced debt-to-equity ratio is a positive, but continued refinancing at favorable rates will be critical.
4. Evaluate NAV recovery: A rebound in NAV would indicate improved portfolio performance and investor confidence.

In conclusion, Oxford Square Capital offers a compelling high-yield opportunity for income investors willing to tolerate volatility. Its defensive portfolio structure and strategic capital management position it to weather a rising rate environment, but the risks of dividend cuts and NAV erosion cannot be ignored. As with any high-yield play, due diligence and active monitoring are essential.