Everyone dreams of generating income when they sleep. Passive income is a coveted goal for many individuals, and one effective way to achieve it is through dividend stocks.
Dividend stocks come in all shapes and sizes. Some companies offer modest payments and yields that have the potential to grow steadily over time. Others that offer lofty payouts can be appealing to investors willing to take the extra risks.
Ares Capital (ARCC 0.83%) and FS KKR Capital (FSK 1.20%) each yield 10% or more annually based on their current share prices and payout levels. Both are business development companies (BDC) -- regulated investment companies that are required by U.S. law to distribute 90% of their net investment income to shareholders every year through interest, dividends, or capital gains. Because of this tax structure, BDCs can be an excellent source of high-yielding dividends to shareholders. As such, these stocks could potentially supercharge your passive income, but consider these risks that could make the dividend payments more volatile before adding them to your portfolio.
1. Ares Capital: 10% dividend yield
Ares Capital provides loans and makes equity investments in middle-market companies in the U.S. It believes middle-market companies are attractive investments because banks have sharply reduced their willingness to fund them in the recent decades. According to S&P Capital IQ LCD, U.S. banks' share of senior secured loans, like those made to middle-market companies, has declined from 33% in 1995 to just 8% in 2021. Banks prefer to lend to larger clients because these loans tend to be less risky and more liquid than middle-market loans.
Ares Capital is the largest BDC in the U.S. and primarily invests in loans to companies with annual earnings before interest, taxes, depreciation, and amortization (EBITDA) of between $10 million and $250 million. These loans aren't without risks. If companies' earnings suffer in a weakening economy, they could be unable to repay their loans.
Today, companies are dealing with elevated uncertainty because the Federal Reserve has aggressively raised interest rates to combat inflation. To mitigate some of this risk, Ares Capital invests in first-lien and second-lien loans, so its debts would get priority over those of other lenders and stakeholders in the event of a bankruptcy liquidation. Its loans are spread across industries, with software and services, diversified financials, and healthcare services comprising the three sectors it lends the most to.
Dividends from BDCs can vary based on income year to year, making these payments more volatile. If there is a downturn that affects its net investment income, its payout will drop as a result. Another thing to remember is that much of the returns investors gain from BDCs are due to their high dividend payouts. Over the past five years, Ares Capital Corporation has delivered 80% returns (with redividends invested), while the stock price has risen just 12%.
Ares Capital delivers a stellar dividend yielding about 10% and can be a solid high-return dividend stock if you are OK with the risks.
2. FS KKR Capital: 14% dividend yield
FS KKR Capital also makes similar investments in privately held middle-market companies in the U.S.
What makes it appealing is that 70% of its loans have variable interest rates, meaning when interest rates rise, so does the yield on its portfolio. The average annual yield on its debt investments jumped from 8.7% in 2021 to 11.2% by the end of 2022.
FS KKR Capital has more than 68% of its assets invested in senior secured first-lien and second-lien loans, prioritizing it in the event of a liquidation. The BDC faces risks similar to those faced by Ares Capital, in that if companies cannot keep up with their rising costs of debt in a challenging environment, then it could be hit by a wave of defaults.
Its business hasn't been showing signs of being under too much stress this year. At the end of the first quarter, 4% of its loans were underperforming, where it is concerned about recovering its principal or interest. That was up slightly from 3% in the same quarter last year. Investors will want to keep a close eye on this metric in the coming quarters, as continued upticks would indicate that more companies are having difficulty repaying their debts.
Over the past five years, the BDC has delivered 25% returns (with dividends reinvested), while the actual stock price has fallen by 36%. FS KKR's lofty 14% yield makes it another appealing ultra-high-yielding dividend stock for income investors willing to take on the associated risks.
