Ares Capital Corporation (ARCC 0.73%) boasts an ultrahigh dividend yield of 9.8%, making it a popular choice among income investors. The company primarily lends to underserved midsize businesses in the U.S. and benefits as high interest rates help it earn even higher returns on its loans.
The stock has delivered solid returns for long-term investors for more than two decades, largely because of its dividend. However, the stock isn't without risks, as economic conditions and interest rates can have a significant impact on its business. In this article, I'll discuss Ares Capital's business, the headwinds it may face, and whether the stock is appropriate for your portfolio.
Ares Capital lends to this overlooked part of the market
Ares Capital is a specialty finance company that makes loans to middle-market companies. It defines middle-market companies as those with earnings before interest, taxes, depreciation, and amortization (EBITDA) between $10 million and $250 million.
Ares Capital has chosen this market segment because banks pass up these companies in favor of larger enterprises, and the stats back them up. According to S&P Global's Capital IQ, U.S. banks' share of senior secured loans, like those Ares Capital makes, has fallen from 33% in 1995 to 8% in 2021.
As a business development corporation (BDC), Ares Capital fills this gap in funding. BDCs are regulated investment companies for tax purposes, meaning they must distribute 90% of their taxable income to shareholders. Because of this tax treatment, BDCs can be an excellent source of high-yielding passive income.
Since going public two decades ago, Ares Capital has delivered market-beating investment returns -- a testament to the business's long-term strength.
Data source: YCharts
These headwinds could affect its dividend payout
Ares Capital's business isn't without risks. Companies have dealt with inflation, rising interest rates, and tightening financial conditions for more than a year as the Federal Reserve aggressively raised interest rates to damp excessive inflation. These middle-market companies could struggle if conditions lead to a slowdown in spending across the economy.
The risk of a recession has been on economists' minds for a while now. Coming into this year, a survey by the National Association for Business Economics found that nearly 60% of forecasters believed the U.S. would enter a recession next year. In its most recent July survey, fewer than 30% of forecasters see a recession in the next 12 months. No recession would be a positive for Ares Capital because it would mean recessionary conditions won't hinder the companies it lends to.
Investors could analyze Ares Capital's current risk by analyzing its portfolio risk, shown in its regulatory filing. The company rates its debt investments based on risk, with a grade of four indicating little risk, while a grade of one indicates that "debt covenants are out of compliance and payments are substantially delinquent."
Currently, 1.4% of its portfolio is rated with a grade of one, up from 0.5% at the end of 2022. Historically, it has done a good job of managing risk. In 2008, during the Great Recession, only 2.44% of its loans fell into that grade one category.
It mitigates default risks in a couple of ways. For one, it spreads its investments across industries so its risk isn't too concentrated. Currently, 22% of its investments are in software and services, followed by financial services at 13%, healthcare services at 11%, and commercial and professional services at just under 10%.
Second, 62% of its investments are in first-lien and second-lien loans, meaning it would get priority over other lenders or stakeholders in the event of a bankruptcy liquidation. The company is also shielded from higher interest rates to some degree since 68% of its loans have floating rate interest rates.
Is it a buy?
Ares Capital thrives because it provides loans to underserved markets that banks tend to avoid and has made a good business out of it. The company has been a solid source of dividends for income investors.
It's not without risks. If we were to get the elusive recession that experts have been predicting for more than a year now, it could see defaults tick up, which could compromise its payout to investors.
As long as you're OK with these risks, Ares Capital is a solid high-yielding stock you can buy today that could boost passive income as part of your diversified portfolio.
