In September, the Federal Reserve cut its benchmark interest rate for the first time in four years. That long-awaited reduction reflected the fact that inflation had cooled off significantly, and signaled that the Fed was pivoting back to a focus on promoting economic growth and employment again. It also indicated that fixed-income investments like CDs and U.S. Treasury bills would become less attractive as their yields declined.
That trend, which has already reduced the 10-year U.S Treasury's yield to 4.1%, is driving many conservative investors away from fixed-income assets and back toward high-yielding dividend stocks. One such stock that has been attracting a lot of attention is Ares Capital (NASDAQ: ARCC), which at its current share price yields a massive 8.9%. Should you invest in it today?
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Why does Ares Capital pay such a high dividend?
Ares Capital is a business development company (BDC) that provides financing for middle-market companies (businesses that generate between $10 million and $250 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) every year). It invests between $30 million and $500 million in debt and equity in each company.
BDCs have risen in popularity over the past two decades as traditional banks reined in their loans to middle-market companies, which were generally considered less reliable borrowers than their larger and better-capitalized peers. That makes BDCs riskier investments than traditional banks, but they also collect higher interest on their loans.
To mitigate that risk, Ares has spread its investments across 525 companies in over 30 different industries. More than 60% of its loans are first and second lien secured loans, which puts it ahead of other creditors if a company goes bankrupt.
But BDCs still borrow a lot of the money they invest or loan to those companies. That's why their leverage generally increases as their portfolios expand -- and they're more sensitive to credit risks than many other financial companies. However, Ares ended its latest quarter with a manageable debt-to-equity ratio of 1.06. By comparison, its smaller peer Main Street Capital held investments in just 194 companies and ended its latest quarter with a debt-to-equity ratio of 0.92.
BDCs, like real estate investment trusts (REITs), must pay out at least 90% of their taxable income to shareholders as dividends to maintain a favorable tax rate. That requirement -- along with their commitment to making riskier (but higher-yielding) investments in smaller companies than banks -- gives them higher yields than many of their industry peers.
Can Ares maintain its momentum over the next few years?
Ares Capital has weathered several major economic downturns since its inception two decades ago, and its shareholders have experienced steep declines at times -- and could do so again if the market crashes. The stock plunged from a high above $20 in early 2007 to about $3 at the nadir of the Great Recession in 2009, but recovered to around $17 in the couple of years that followed.
After trading largely sideways for the better part of a decade, the stock was in the neighborhood of $19 per share in early 2020 before the COVID-19 crash drove it below $10 again. Management reduced its dividends during both downturns.
BDCs are generally valued by their net assets per share, and can trade at a premium or a discount to that metric. From the end of 2020 to the end of 2023, Ares' net assets per share rose from $16.97 to $19.24. That figure had climbed to $19.61 at the end of this June. At its current price of $21.65, Ares Capital only trades at a 10% premium to its net asset value.
By comparison, Main Street Capital trades at $52.35 as of this writing -- which is nearly 80% higher than its $29.80 in net assets per share at the end of June. Main Street also has a lower forward yield of 7.8%. In addition, based on its forward price-to-earnings ratio of 10, Ares Capital looks dirt cheap. Main Street looks a bit pricier at 13 times forward earnings.
A great play on lower interest rates
All of those qualities suggest that Ares Capital -- which has generated impressive total returns of 255% over the past 10 years -- should head higher over the next few years as interest rates decline. It might not outperform higher-growth stocks in a bull market, but its broad diversification, disciplined risk management strategies, and low debt levels all suggest it will remain a safe high-yield play for income-oriented investors.
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