Is This 16% Yield an Income Investor's Dream or Too Good to Be True?

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Is This 16% Yield an Income Investor's Dream or Too Good to Be True?

investing ideas :: 9hrs ago :: source - motley fool

By Keith Speights

Closed-end funds (CEFs) are popular with many income investors because of their juicy distributions. Yield-hungry investors also often favor business development company (BDC) stocks for the same reason.

FS Credit Opportunities Corp. (NYSE: FSCO) offers two for the price of one. It's basically a BDC wrapped in a CEF. The fund is operated by Future Standards, a global alternative asset manager with $86 billion in assets under management.

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The combination CEF/BDC's distribution yield currently tops 16%. Is this yield an income investor's dream? Or is it too good to be true?

Image source: Getty Images.

Definitely no dream

I'll cut to the chase. FS Credit Opportunity's ultra-high yield definitely isn't an income investor's dream. There's too much baggage to meet that lofty bar.

For one thing, the distribution yield is unusually high in large part because the CEF's price has plunged significantly. FS Credit Opportunities' share price is now roughly 35% below its mid-2025 peak.

Worries about the private credit market that BDCs serve have increased in recent months. Concerns further intensified with the so-called "SaaSpocalypse," a sell-off of SaaS stocks. Investors fretted that artificial intelligence (AI) could disrupt the business models of many SaaS companies. BDC stocks were also hit hard because many BDCs provide significant funding to software developers.

Income investors also can't be dreamy about FS Credit Opportunities after the fund's board cut the distribution by 14% earlier this month. The CEF's yield was even higher before this move.

Not a nightmare, though

Do these factors make FS Credit Opportunities a nightmare for income investors rather than a dream? I wouldn't go that far.

Around 78% of the CEF's assets involve floating-rate loans. When interest rates fall, FS Credit Opportunities' income can also slip. Andrew Beckman, FS Credit Opportunity's head of global credit and portfolio manager, explained in the press release announcing the recent distribution cut, "As interest rates have declined, we believe it is appropriate to adjust the monthly distribution in line with the current rate environment."

Were there other more concerning factors behind the distribution cut? Nope. Beckman stated that the decision wasn't "driven by credit quality or portfolio performance." FS Credit Opportunities' portfolio is performing pretty well. Its non-accruals (loans where borrowers have fallen behind in payments) remain low at around 3%. The CEF's monthly distribution remains fully covered by net investment income.

Worries about how AI's disruption of SaaS companies might impact FS Credit Opportunities could be overblown, too. At the end of 2025, the fund's exposure to software and services was only 8.8%. No software company ranked among the CEF's top 10 holdings.

Beckman addressed the "SaaSpocalypse" head-on in FS Credit Opportunities' fourth-quarter earnings call. He acknowledged that software providers with low switching costs and minimal differentiation could be at risk from AI disruption. However, Beckman argued that companies with "deeply embedded systems of record, security and control layers, and vertical software with extensive integrations and compliance-driven switching costs" could benefit from AI rather than be replaced by it. He said that FS Credit Opportunities focuses on businesses that are generating strong cash flow and have "defensible business models."

Check your risk tolerance

No, FS Credit Opportunities' 16% yield isn't an income investor's dream. However, it isn't too good to be true, either.

If interest rates stabilize, this CEF could look more attractive to many investors. I suspect the chances of this happening are better now than they were earlier this year. The conflict with Iran has driven oil prices significantly higher. If the crisis is prolonged, inflation could resurge. The Federal Reserve would be less likely to cut interest rates further in this scenario.

In the meantime, FS Credit Opportunities is trading at a 31% discount to its net asset value (NAV). I could understand a moderate discount to NAV, but this seems to reflect unwarranted extreme pessimism about the fund, in my view.

To be sure, FS Credit Opportunities is too volatile for many income investors. Other high-yield dividend stocks will be better picks if you're risk-averse. However, it could be appealing to more aggressive investors. Check your risk tolerance before buying this CEF.

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Keith Speights has positions in FS Credit Opportunities. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

This article was originally published by The Motley Fool