OAKTREE (LUX.) II Société D’Investissement À Capital Variable – Fonds D’Investissement Spécialisé Annual Report and Audited Financial Statements September 30, 2020
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OAKTREE (LUX.) II Société d’Investissement à Capital Variable – Fonds d’Investissement Spécialisé Annual Report and Audited Financial Statements September 30, 2020 R.C.S. Luxembourg: B 199.241 Oaktree (Lux.) II Annual Report and Audited Financial Statements September 30, 2020 Table of Contents General Partner and Investment Manager Report ................................................................................ 3 Statement of Assets and Liabilities.................................................................................................... 6 Statement of Operations................................................................................................................... 7 Statement of Changes in Net Assets .................................................................................................. 8 Statement of Changes in Shares Outstanding ...................................................................................... 9 Statistical Information ..................................................................................................................... 10 Oaktree (Lux.) II - European Credit Fund Schedule of Investments and Other Net Liabilities.................................................................... 11 Open Forward Foreign Exchange Contracts ............................................................................. 19 Notes to the Financial Statements...................................................................................................... 20 Independent Auditor's Report ........................................................................................................... 28 General Information........................................................................................................................ 31 Board of Directors and Company Information .................................................................................... 32 No subscription can be received on the basis of financial reports alone. Subscriptions are only valid if made on the basis of the current Offering Circular, supplemented by the latest available Audited Annual and Unaudited Semi-Annual Report and Accounts if published thereafter. Annual Report and Audited Financial Statements 2 Oaktree (Lux.) II General Partner and Investment Manager Report We are pleased to present the Annual Report and Audited Financial Statements for Oaktree (Lux.) II (the “Company”) for the year ended September 30, 2020. Investment Objective The overall investment objective of the Company is to invest its assets in securities and other assets in which a specialised investment fund governed by the SIF Law is permitted to invest with the aim of spreading investment risks and providing Investors with the results of professionally managed investment portfolios. The investment objective of Oaktree (Lux.) II European Credit Fund (the “Sub-Fund”) is to deliver an attractive total return by investing in a diversified portfolio of senior loans, floating-rate notes, second-lien loans, mezzanine loans and high yield bonds. The Sub-Fund may, subject to the restrictions set out in section 3, "Risk Diversification", and "Investment Restrictions" section of the Memorandum, also invest in any other debt instruments (including, without limitation, subordinated or unsecured loans, direct loans, private placements, bridge loans for high yield bond commitments and rated debt of collateralised loan obligations ("CLOs")). The Sub-Fund will focus on investing in (a) debt instruments of borrowers or issuers whose debt is rated below investment grade and that are organised or have a substantial portion of their operations, assets or business located in Europe and (b) debt instruments denominated in a European currency of developed market borrowers or issuers outside Europe whose debt is rated below investment grade, provided that the Sub-Fund may, subject to the cap set out in "Investment Restrictions" section of the Memorandum, invest in debt instruments of borrowers or issuers that are organised or have a substantial portion of their assets or business in jurisdictions outside Europe. The Sub-Fund will invest primarily in Euro-denominated debt instruments, but may hold investments denominated in other currencies as well. At September 30, 2020 the total net assets of the Company was USD 47,960,799.09. Oaktree European Credit Fund Financial markets continued to recover in the third quarter, shaking off much of the fear and uncertainty that characterized the sell-off earlier this year. The rebound reflected a recovery in economic activity and extraordinary fiscal and monetary stimulus. However, the later part of the quarter brought headwinds in the form of softer economic data and concerns about a possible second wave of the coronavirus in Europe. Presented below is the performance of the Fund and its benchmarks for the periods ending September 30, 2020. Fourth First Second Third FYTD Quarter Quarter Quarter Quarter Sept 2019 2020 2020 2020 2020 Oaktree European Credit Fund - Before fees and expenses 1.0% (14.3)% 11.3% 2.2% (2.5)% - After fees and expenses 0.9% (14.4)% 11.1% 2.1% (2.9)% EURIBOR 3 Months + 4 0.9% 0.9% 0.9% 0.9% 2.8% European High Yield Bond/Senior Loan Custom Index1 1.4% (14.5)% 11.6% 2.7% (2.0)% 1Custom index: 50% ICE BAML HY Issuers Constrained Index Ex. Russia and Financials (EUR hedged), 50% Credit Suisse Western European Leveraged Loan Index (EUR hedged) Annual Report and Audited Financial Statements 3 Oaktree (Lux.) II While we strive to outperform in all conditions, our quality bias left the Fund trailing in a rally that favored the riskiest segment of the market. The lowest-priced tier of loans (those trading below 70 cents) staged an astonishing rally, with returns above 20% in the quarter! Similarly, though not to such an extreme, the lowest-quality segment of the high yield bond market was the highest returning over the third quarter. Despite trailing the index a bit, we were gratified to see that our active rotations into oversold companies and sectors in the second quarter rewarded us with a 2.2% gross return. The European high yield bond market was up 2.6% for the quarter, while the senior loan market delivered a marginally higher return of 2.8%. As would be expected in a “risk-on” environment, CCC-rated bonds and loans (which account for 8% and 7% of their respective benchmarks) were the top performers, returning 2.9% and 5.4% respectively. For the year-to-date period there is a wide dispersion between the winning and the losing industries. Some defensive industries and “stay-at-home” sectors have fully recovered, while sectors facing severe disruption from Covid-19 continue to languish. Energy–avictimoflowcommodityprices–remainstheclearlaggard. The new issue market for European high yield bonds has been remarkably untroubled by the coronavirus pandemic, with new issue supply of €21 billion in 3Q20. This takes the year-to-date tally to €59 billion – a level that has not been reached since 2014. BB-rated bonds accounted for 72% of new issue volumes (slightly above their 60% weighting in the benchmark), with proceeds mainly used to boost liquidity and for refinancing activities. Conversely, the new issue market for European senior loans continues to be muted. Issuance was €16 billion, an increase from €11 billion in the previous quarter. This brought total issuance for the year to date to €54 billion, 15% lower than the equivalent period for 2019. The dearth of new loan supply has added to the positive technicals during the quarter, as demand for the asset class continues to develop. Most notably, the European CLO market has returned to life, with new warehouses opening. Conditions for primary CLO issuance were supported by increased demand for new issue CLO liabilities, which drove a 50 basis point decline in AAA-rated CLO liability spreads over the quarter. With a light primary issuance calendar and renewed demand from CLOs, the technical support for the European senior loan market seems likely to remain robust. Despite significant rating agency downgrades so far this year (particularly in March and April), the European high yield bond and senior loans markets have yet to see a significant pick up in their default rates. Unprecedented government and central bank support has helped to suppress defaults. Credit Suisse recorded six defaults in the European high yield market in the third quarter, with two in the European senior loan market, increasing the trailing twelve-month default rates to 2.9% and 1.1%, respectively. We are pleased to report that we had no defaults in our portfolio in the third quarter. However, the overall outlook for the sectors is less promising: there is more debt in the system, and company earnings are unlikely to recover quickly, while stimulus measures cannot be maintained indefinitely. Overall, we believe European high yield bond and senior loans investors are being fairly compensated for incremental credit risk. That said, in the short term, both markets are likely to remain uncertain as investors grapple with the fallout from the coronavirus pandemic and a seemingly endless list of economic and political uncertainties. In our recent portfolio adjustments, we have chosen to reduce exposure to some of the cyclical industries where our credits have enjoyed a sharp recovery to the point where yield spreads are uncompelling. We maintain that our portfolio tilt to higher quality loans and bonds remains appropriate in light of these risks. In the medium-to-long