Saratoga Investment Corp. (SAR): Navigating Volatility with Disciplined Leverage and Sustainable Dividends

In an era marked by geopolitical tensions, fluctuating interest rates, and sluggish deal flow, Saratoga Investment Corp. (SAR) has emerged as a beacon of resilience within the business development company (BDC) sector. While macroeconomic headwinds have tested many peers, SAR's focus on strategic leverage management, portfolio quality, and dividend sustainability has positioned it as a compelling investment opportunity. Let's dissect the financials and strategy behind its recent performance to assess its long-term viability.

Strategic Leverage Management: A Buffer Against Uncertainty

SAR's leverage ratios reflect a deliberate balance between growth and risk mitigation. As of May 31, 2025, its regulatory leverage ratio stood at 163.8%, a slight increase from the prior quarter but well within its 200% regulatory cap. However, the effective leverage ratio—calculated using NAV—rose to 188.1%, underscoring the importance of its robust liquidity position. With $430 million in undrawn borrowing capacity (including $294 million in credit facilities and $136 million in SBA debentures), SAR maintains ample flexibility to navigate short-term challenges or capitalize on opportunistic investments.

This approach contrasts with peers that have overextended in pursuit of yield. SAR's conservative stance is further evidenced by its portfolio composition: 86.9% of investments are in first-lien term loans, a category historically less volatile than riskier second-lien or mezzanine debt. The minimal exposure to complex instruments like collateralized loan obligations (CLOs) reduces dependency on secondary markets, a critical advantage in turbulent environments.

Portfolio Quality: A Foundation of Resilience

SAR's portfolio demonstrates both depth and defensive characteristics. Key metrics include:
- Credit Quality: 99.7% of assets are in the highest credit category, with only two non-accrual investments (Zollege and Pepper Palace) accounting for 0.3% and 0.6% of fair value, respectively.
- Fair Value Performance: Despite a 1.7% unrealized appreciation in its core non-CLO portfolio, the overall portfolio remains 2.1% below cost—a sign of cautious valuation.

The company's proactive risk management is evident in its resolution of four troubled investments through sales and restructurings. This discipline, paired with a weighted average yield of 11.5% on core BDC assets, ensures steady income streams even as short-term interest rates decline.

Dividend Sustainability: Yielding 11.8% with Caution

SAR's dividend yield of 11.8% (based on a $25.44 stock price) is compelling, but its sustainability hinges on net investment income (NII) coverage. For the quarter, adjusted NII per share was $0.66, while the dividend remains at $0.75 annually ($0.25 per month). This creates a coverage ratio of ~88%, raising red flags. However, two mitigating factors emerge:

1. Net Income Cushion: SAR reported $0.91 EPS for the quarter, driven by $2.2 million in realized gains from repayments and equity realizations. These one-time gains supplement NII, reducing dependency on recurring income.
2. NAV Stability: The NAV per share dipped slightly to $25.52 but remains above $25 for three consecutive quarters, providing a buffer against dividend cuts.

Moreover, SAR's history of gradual dividend growth—from $2.86 in 2024 to $2.96 in 2025 and now $3.00 in 2026—suggests management's confidence in maintaining payouts. The recent halt in share repurchases (none in Q1 2026) further prioritizes dividend funding over capital returns.

Outperforming the BDC Sector: ROE Leadership

SAR's trailing twelve-month ROE of 9.3% handily beats the BDC industry average of 7.0%, a gap widened by its disciplined capital allocation. While revenue dipped 16% year-over-year due to lower interest rates and AUM declines, SAR's focus on expense control (reducing the prior quarter's $2.4 million excise tax) and asset optimization has stabilized returns.

Headwinds and Risks: Interest Rates and Deal Drought

No investment is without risks. SAR faces two key challenges:
1. Interest Rate Pressure: The core portfolio's yield has fallen to 11.5% from 12.6% a year ago, reflecting broader declines in short-term rates. This could compress NII further unless reinvestment occurs at higher yields.
2. Slowing Deal Flow: AUM dropped 11.6% year-over-year to $968 million, as macroeconomic uncertainty stifled originations. SAR's $50.1 million in new investments this quarter, versus $64.3 million in repayments, signals a cautious approach to deployment.

Conclusion: A Buy with an Eye on Liquidity and Strategy

Saratoga Investment Corp. (SAR) presents a nuanced but compelling case for investors seeking income and resilience in a volatile market. Its 11.8% dividend yield, 9.3% ROE, and $430 million undrawn liquidity justify a buy rating, even amid near-term headwinds. While NII coverage is tight, the combination of net income support, stable NAV, and a disciplined management team suggests the dividend is sustainable.

Recommendation:
- Hold for Income: SAR's dividend yield and defensive portfolio make it a strong fit for income-focused portfolios.
- Monitor Leverage and AUM: Investors should track SAR's ability to grow AUM through new originations and manage leverage as interest rates stabilize.
- Consider Pairing with Cyclical Plays: SAR's defensive nature complements riskier bets in sectors like tech or real estate.

In a world where certainty is scarce, SAR's blend of prudence and yield stands out—a testament to the power of strategic discipline in turbulent times.

Disclaimer: This analysis is for informational purposes only and does not constitute financial advice. Always conduct independent research or consult a financial advisor before making investment decisions.