When surveying the investment universe for options, income investors need to be careful to avoid yield traps. A yield trap is a company that pays a potentially unsustainable dividend.
A yield trap can come about for a few reasons, including a burdensome debt load, a declining business, or an elevated dividend payout ratio. Sporting a whopping 10% dividend yield, investors may initially think that the business development company (BDC) Ares Capital (ARCC 0.73%) is a yield trap. But here is why that doesn't appear to be the case.
Ares Capital is the crème de la crème of BDCs
Over the past three decades, the proportion of loans made to middle-market companies by U.S. banks has dropped precipitously to around 8% today. That is because banks have become more conservative and would rather lend to more mature companies with better credit ratings. For the sake of clarity, companies must typically generate between $10 million and $250 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) annually to fit into the middle-market category.
Arguably no company has filled this funding gap as much as Ares Capital. The company's $21.5 billion investment portfolio as of June 30 is the biggest in the BDC industry. Access to this capital allows the BDC's 475 clients to expand and capitalize on growth opportunities. In exchange for these funds, Ares Capital receives either an equity stake in its clients, debt investments that pay above-average interest, or some mix of the two.
Thanks to diligent investments across a broad range of industries, the BDC has been able to deliver market-beating investment returns to shareholders throughout its history. And while many companies have been hurt by higher interest rates, the contrary has been true for Ares Capital. That is because the company can use its investment-grade balance sheet to secure financing at lower interest rates. The BDC lends to clients at much higher rates to compensate for increased risk, which results in a sizable investment spread between the interest paid on debt and the interest received from investments.
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A well-supported dividend
Ares Capital's lofty dividend yield makes the S&P 500 index's 1.6% yield seem tiny by comparison. But this dividend doesn't seem too good to be true for income investors.
Through the first six months of 2023, Ares Capital's dividend payout ratio was a modest 83.5%. Such a low payout ratio for its industry gives the company a buffer to withstand a temporary downturn in its profits if a recession were to materialize. It also leaves the company with retained earnings to continue expanding its investment portfolio, which will drive future growth. These factors should lead Ares Capital to build on its 13-plus-year streak of stable or rising dividends.
The stock looks to be fairly valued
As an ultra-high-yielding dividend stock, it shouldn't be a surprise to learn that the bulk of Ares Capital's returns are generated from dividends. Shares of the stock have gained just 3% so far in 2023, less than a quarter of the gain in the S&P 500 index. Trading at a price-to-book (P/B) ratio of 1, the BDC's valuation is about the same as its 13-year median P/B ratio of 1. That's a rational valuation based on the company's fundamentals. From my perspective, this sets up Ares Capital as a clear buy for income investors at the current price of about $19 share.
