I'm on a mission to grow my passive income streams to the point where they'll cover my basic living expenses. That would enable me to achieve financial independence.
Investing in high-yielding dividend stocks is a key component of my investment strategy. I recently added a new one to my portfolio: Ares Capital Corporation (ARCC +0.52%). With a 9.8% dividend yield, it will enable me to generate a lot of passive income.
Image source: Getty Images.
An intro to Ares Capital
Ares Capital is a business development company (BDC). As a BDC, it provides capital to other companies to help them fund their operations and expansion. Ares Capital is one of the largest direct lenders in the country. It primarily originates loans to private middle-market companies (those with between $10 million and $1 billion in annual revenue).
It's part of the Ares Management franchise. Ares Management is a world leader in alternative investments. It had $596 billion in assets under management (AUM) across credit, real assets, private equity, secondaries, and other businesses. It's a leader in credit, with $391.5 billion in AUM. Ares Capital benefits from being part of the broader Ares Management platform as it has access to investment opportunities sources by its parent.
NASDAQ: ARCC
Key Data Points
Ares Capital's investment portfolio stood at $28.7 billion at the end of the third quarter, spread across 587 portfolio companies. Its largest investment was 1.5% of its assets, while the average is 0.2%. This diversification helps reduce risk. The bulk of the company's investments are senior secured loans (71% of its portfolio). These secured loans have the highest priority claims on any assets should one of its portfolio companies file for bankruptcy. Ares' focus on secured debt has paid off over the years, as it has a 0% average annualized realized loss on its loan investments since its inception. That's significantly better than the average bank (a 0.6% annualized net realized loss rate) and its fellow BDCs (a 1.1% annualized net realized loss rate).
A deeper look at the dividend
The loans held by Ares Capital generate interest income, the bulk of which it distributes to investors. Because it's a BDC that has also chosen to be a regulated investment company for U.S. federal income tax purposes, the IRS requires it to distribute 90% of its taxable income to shareholders to avoid paying corporate income taxes on this income. That high payout ratio is why the company offers such a high dividend yield.
High-yielding dividend stocks are often higher-risk investments. Many high-yielding companies have had to reduce their payouts in the past when they encountered financial difficulties. That has been the case for many BDCs.
However, Ares has delivered 16 years of stable or increasing base dividend payments. While the company hasn't increased its dividend every year, it has risen 26% over the past decade. The company has also occasionally paid supplemental dividends to ensure it reaches the required 90% payout ratio.
The company's conservative investment approach and strong balance sheet provide a solid foundation for the dividend. It generated $0.50 per share of core earnings during the third quarter, more than enough to cover its $0.48 per share dividend. The company has also banked $1.26 per share of income that it doesn't have to pay out in dividends, but could if needed, which gives it a more than two-quarter cushion. Additionally, Ares has a very strong balance sheet, with a leverage ratio of around 1.0 times, well below the upper end of its target range of 1.25 times. That gives it room to take on more leverage to expand its portfolio and generate additional interest income if needed to boost its dividend coverage. These and other factors drive the company's confidence that it can maintain its current dividend level for the foreseeable future, even if lower interest rates impact its earnings.
An appealing income stream
Ares Capital pays a high-yielding dividend backed by a rock-solid loan portfolio. I'm excited to add the company's lucrative income stream to my portfolio. I believe it can supply me with a stable income stream, which I can grow by adding to my position over time.
