The world of dividend stocks inspires dreams of passive income, and Ares Capital (ARCC 0.83%) is one stock that has delivered for investors since its debut two decades ago.
As a business development corporation (BDC), Ares Capital is a regulated investment company for tax purposes -- meaning rules require it to distribute 90% of its taxable income to shareholders. Because of this, income investors flock to Ares Capital for its fat 10.7% dividend yield. Long-term investors who purchased shares in the BDC during its initial public offering (IPO) in 2004 have enjoyed stellar returns. Read on to see how much $1,000 invested in the company would be worth today.
If you invested $1,000 in Ares Capital's IPO, here's what you would have today
Ares Capital is a specialty finance company that makes debt and equity investments. Its primary investments are loans made to middle-market companies, which it defines as companies with earnings before interest, taxes, depreciation, and amortization (EBITDA) between $10 million and $250 million.
Ares Capital believes middle-market companies are a neglected segment in the loan market, with banks de-emphasizing these companies in favor of larger clients. The numbers back it up. According to S&P Global Capital IQ LCD, U.S. banks' share of senior secured loans went from 33% in 1995 to 8.1% in 2021.
Ares Capital has delivered for investors ever since its debut as a public company. If you bought $1,000 in stock in Ares Capital during its initial public offering and reinvested your dividends, today you would be sitting on $8,287. To put this in perspective, $1,000 invested in the S&P 500 with dividends reinvested during the same period would be worth $5,169.
Data source: YCharts
The risks of investing in a BDC
Ares Capital has a $21.8 billion investment portfolio and is the largest publicly traded BDC in the U.S. Lending to middle-market companies exposes Ares Capital to risks banks don't want to deal with. In compensation, it tends to charge higher interest rates than conventional lenders.
Because the market for these loans isn't very liquid, Ares Capital issues loans without using a syndicate (financing offered by a group of lenders) or selling part of the loans in the open market. However, it could have difficulty finding a buyer if it needed to raise capital quickly and was forced to sell some of its loans. This risk is one reason it offers a high dividend yield.
It also faces risks in an economic downturn if several of its clients cannot repay their loans. One way it looks to mitigate this risk is by spreading its loans across various businesses and industries. Last year, 22% of its loans were to companies in software and services, 13% were diversified financial companies, and another 11% were to healthcare companies.
Also, 43% of its portfolio is in first-lien senior secured loans, meaning it would get preference over other debt and equity holders in the event of a bankruptcy and liquidation. Another 18% of its portfolio is in second-lien senior secured loans, which are given the second-highest priority in liquidation.
Capitalizing on tight lender markets and high interest rates
Ares Capital management noted that the company faced headwinds last year in a risk-off environment. It cited inflation, tightening financial conditions due to rising interest rates, and a potential recession as factors that reduced demand for credit.
Although this could cause a pullback in lending to middle-market companies, Ares Capital sees it as an opportunity. A reduction in competition amid volatile lending markets is an opportunity for Ares Capital to gain market share and capitalize on higher interest rates. Last year the weighted yield on its portfolio rose from 7.9% to 10.6% by the end of the year.
Image source: Getty Images.
Consider this before investing in Ares Capital
Ares Capital's big dividend payout makes it appealing to income-minded investors. It has delivered excellent returns for two decades, navigating challenging markets during the 2008 Great Recession and the 2020 pandemic-induced recession.
The BDC will face more challenges this year. For example, companies may be unable to pay the ever-increasing interest costs to pay down their debt on variable-rate loans. Additionally, a recession in the U.S. that results in a wave of defaults across middle-market companies could threaten its dividend payout.
Investors should be aware that the stock faces volatility if economic conditions worsen. If you're willing to bear those risks, Ares Capital is a solid high-yield dividend stock that can deliver income as part of your diversified portfolio.
