What's the old saying? If something sounds too good to be true, it probably is?
That's why a bunch of investors might be wary of taking on a position in Ares Capital (ARCC 0.24%), particularly right now. The business development company's current dividend yield of 10.3% seems unrealistically high compared to the S&P 500's (^GSPC 0.02%) yield of 1.7%, even if interest rates are soaring.
Well, the sky-high dividend yield is legitimate, meaning the company has been making real dividend payments at that rate. As you might suspect, however, there's something of a catch involved here.
Ares Capital, up close and personal
Don't misunderstand; a "catch" doesn't mean Ares' business model is illegal, immoral, or even misleading. It's simply to say that investing is ultimately about balancing risk and reward. The near-term reward for owning a piece of Ares Capital is above-average income, while the risk is that Ares Capital won't be able to continue making dividend payments at its present pace.
You should also know that while the dividend yield is strong, the payment itself isn't entirely consistent from one year to the next. Neither is its payout growth, for that matter.
Data source: Ares Capital Corporation. Chart by author. Dividends include quarterly dividends as well as special dividends.
But first things first.
Ares Capital is a business development company, or BDC. That just means it provides capital to up-and-coming companies that are otherwise underserved by the conventional banking industry. Sometimes, this capital is raised in exchange for equity, although it's usually supplied in the form of a loan. The bulk of any net interest income earned is passed back to Ares Capital shareholders in the form of dividends.
As of the latest look, Ares is a lender to more than 400 midsized outfits including somewhat-familiar names such as Banyan Software, automotive company McLaren, PetVet Care Centers, and OpenMarket, just to name a few.
There's the risk, by the way. These companies tend to be too big to be highly nimble but are often too small to be highly competitive against major players in their industries. They still need cash, though, and they'll pay above-average interest rates to get it -- on the order of 2% to 3% above the normal market rates. That's why the BDC's return on loaned money is markedly higher than returns being achieved by conventional lenders like banks and also why its dividend is well above average. Ares' investment committees' job is just figuring out which businesses of this ilk will actually be able to make their loan payments.
The thing is, Ares' managers do this job exceedingly well. Between its dividends and the growth of the stock's net asset value, Ares has consistently outperformed its rival BDCs for the past several years. Its returns have been less volatile than those of its competitors as well. Indeed, it's the only business development company of its size to boast positive net returns since its 2004 public offering.
A storm's brewing
Impressed? You should be. Ares Capital consistently does something that's tough to do. As the old adage goes, though, it's time to pay the piper ... maybe.
As is the case with banks, higher interest rates ultimately lead BDCs to higher profit margins on the loans they make. The company's third-quarter presentation suggests that a 100-basis-point increase in base rates will drive its core per-share earnings up to the tune of 14%, while a 200-basis-point uptick will translate into a 23% increase in per-share profits. That's because a big chunk of the loans in its portfolio are floating-rate loans, translating into higher interest payments when base rates are rising. (Rates have risen in the meantime, by the way.)
There's a growing flip side to this bullish thesis, however. That is, high interest rates paired with a weakening economy make it tough for midsized companies to continue making loan payments. In this scenario, Ares' highly leveraged business model can quickly become a major liability.
And the world's starting to get worried. Fitch Ratings cautioned in November that BDCs' "portfolios remain concentrated in investments underwritten in a very competitive market, characterized by fewer/looser covenants, higher underlying leverage and weaker lender flexibility in credit documentation." Fitch adds, "Continued valuation volatility and/or an increase in realized losses in 2023 could put pressure on asset coverage cushions for BDCs, particularly those that are leveraged at or above the high-end of their targeted ranges."
Fitch's analysts aren't the only ones voicing concern, either. Neil Unmack and Jonathan Guilford wrote for Reuters just last month that BDCs' stocks "traded in early December at a 12% discount to their stated net asset value, implying losses down the line." Marathon Asset Management's global head of business development, Jason Friedman, also recently told Reuters, "Some of those [private lender/BDC] companies -- particularly in the mid-market space -- will face real difficulty, especially if it's not, as the market is anticipating, a shallow recession."
Whether Ares is equipped to sidestep this headwind remains to be seen. But it's not a stretch to suggest that at least part of the recent rise in Ares Capital's dividend yield reflects growing investor worry about its foreseeable future.
Too good to be true? That's not quite the right question.
Investors mulling a new position in Ares Capital should understand that neither the market's worst-case scenarios nor its best-case scenarios ever come to fruition. The company probably will bump into the headwinds of a credit crisis stemming from high interest rates and economic weakness. The company will also, however, probably continue collecting the bulk of the interest payments it's due anyway simply because its portfolio is made up of businesses capable of surviving and economic downturn. Only time will tell how -- and how much -- this tug-of-war will rattle the stock.
What we do know right now is that even if only some of the stock's recent dividend is paid out in 2023, its current yield of 10.3% still makes it one of the better income-producing bets for uncertain times.
