Ares Capital (ARCC 0.73%) is a captivating stock for investors looking to generate income from their portfolio. The allure of its high 10% dividend payout makes it a popular choice for those seeking large quarterly payments.
Before taking the plunge and buying the stock, however, there are some things you should know about Ares Capital. The company caters to an underserved market, but it could face challenges in an economic recession. Here are five facts you should consider before deciding if Ares Capital is the stock for you.
1. Ares Capital is the largest publicly traded business development company in the U.S.
Ares Capital is a specialty finance company known as a business development corporation (BDC). BDCs invest in debt or equity in companies, primarily in the U.S., and tend to be registered as Regulated Investment Companies, which requires them to distribute 90% of their income to investors. In return, they are exempt from federal taxes and can be excellent stocks for income-focused investors.
With over $10 billion in net assets, Ares Capital Corporation is the largest publicly traded BDC in the country.
2. It serves unmet needs in middle-market lending
Ares Capital lends to middle-market companies, or those with earnings before interest, taxes, depreciation, and amortization (EBITDA) between $10 million and $250 million.
This segment of the market appeals to BDCs because banks overlook it. For several years, banks have shifted from making senior secured loans, like those Ares Capital makes, to middle-market companies. According to S&P Global Capital IQ, U.S. banks' share of senior secured loans fell from 33% in 1995 to 8% in 2021. The shift is because banks prefer to lend to large enterprises whose loans are less risky and more liquid than those of smaller counterparts.
3. Ares Capital uses leverage to increase its returns
The BDC yields investors nearly 10%, making it a popular stock for income investors. BDCs boost this payout by using leverage (borrowing funds to make investments) to boost shareholder returns. However, the use of leverage could also exacerbate losses in a poor economic environment. Ares Capital's debt-to-equity ratio of 1.08 is below the BDC average of 1.16, showing its more conservative use of leverage.
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4. 68% of Ares Capital loans have floating interest rates
Ares Capital's portfolio investments are valued at $21 billion. Of this total, 68% of the investments have floating interest rates. Floating rates matter in today's economic backdrop because the Federal Reserve has rapidly increased interest rates to try and lower elevated inflation.
In the first quarter of 2022, when the Federal Reserve first began raising interest rates, Ares Capital's weighted average yield on its investments was 8.9%. This figure has risen to 12.2% in its most recent earnings.
5. A deep recession could impact Ares Capital's cash flow
Loans to middle-market companies present a good opportunity for BDCs like Ares Capital. However, they also face some downside risks. For example, the market for middle-market loans isn't as liquid, meaning companies can't sell these assets as quickly and may have to take significant losses if they have to sell these loans in a crunch.
Not only that, but the company's use of leverage and its client base makes it sensitive to economic downturns. If a deep recession occurs, its borrowers may be unable to generate the cash flows needed to pay down their debts. If enough defaults occur, it would significantly impact the company's cash flows and dividend payout.
To mitigate some of this risk, Ares Capital invests across various industries. In addition, 60% of its loans are first-lien or second-lien senior secured loans -- making it one of the first creditors paid off in a liquidation event.
This high-yield dividend stock isn't for everyone
Ares Capital presents an enticing prospect as an ultra-high-yield dividend stock. But it's not without risks. It caters to smaller businesses that could be vulnerable in a deep economic downturn. In return, investors get a juicy payout every quarter. As a long-term investor, you must weigh these risks and rewards and decide whether this high-yield dividend suits your portfolio.
