What is the old saying? If something sounds too good to be true, it probably is?
This is why a bunch of investors might be wary of taking a position Ares Capital (ARCC 2.82%), especially right now. Business Development seems unrealistically high compared to the company’s current dividend yield of 10.3%. S&P 500of (^GSPC 1.28%) A yield of 1.7%, even if interest rates rise.
Well, the sky-high dividend yield is legit, which means the company is paying actual dividends at that rate. As you may suspect, however, there is a catch involved here.
Ares Capital, up close and personal
Don’t get me wrong; A “catch” does not mean that Ares’ business model is illegal, unethical or even misleading. It’s simply saying that investing is ultimately about balancing risk and reward. The near-term reward for owning a share of Ares Capital is above average earnings, while the risk is that Ares Capital will not be able to continue paying dividends at its current pace.
You should also know that while the dividend yield is strong, the payout itself is not completely consistent from one year to the next. Not even a pay rise for that.
But first things first.
Ares Capital is a business development company, or BDC. This means it provides capital to up-and-coming companies that are otherwise missed by the conventional banking industry. Sometimes, this capital is raised in exchange for equity, although it is usually provided in the form of a loan. The majority of any net interest income is returned to Ares Capital shareholders in the form of dividends.
As of recent appearances, Ares is home to more than 400 mid-sized apparel lenders including some familiar names such as Banyan Software, automotive company McLaren, Petvet Care Center and OpenMarket, to name just a few.
There are risks, by the way. These companies tend to be too large to be highly nimble but often too small to be highly competitive against the major players in their industry. They still need cash, though, and they’ll pay above-average interest rates to get it — 2% to 3% higher than normal market rates. That’s why BDC’s return on borrowed money is significantly higher than that earned by conventional lenders like banks, and why its dividend is above average. Ares’ investment committee’s job is just to find out if businesses of this ilk will actually be able to pay their debts.
The thing is, managers at Ares do this very well. Between its dividend and the stock’s net asset value growth, Ares has consistently outperformed its rival BDC over the past few years. Its earnings have been less volatile than those of its competitors. In fact, it is the only business development company of its size to boast a positive net return since its 2004 public offering.
A storm is blowing
Fascinated? You should. Ares Capital consistently does things that are hard to do. As the old saying goes, though, it might be time to pay the piper…
As with banks, higher interest rates ultimately lead BDCs to higher profits on their loans. The company’s third-quarter presentation suggested that a 100-basis-point increase in the base rate would lift its core earnings per share to 14%, while a 200-basis-point uptick would translate to a 23% increase. Earnings per share. That’s because a large portion of the loans in its portfolio are floating-rate loans, which pay higher interest when the base rate rises. (Rates have since risen, however.)
But there is a growing flip side to this bullish thesis. That is, high interest rates associated with a weak economy make it difficult for medium-sized companies to continue to pay off debt. In this scenario, Ares’ highly leveraged business model could quickly become a major liability.
And the world began to worry. Fitch Ratings warned in November that BDC’s “portfolios remain concentrated in investments underwritten in very competitive markets, characterized by low/loss contracts, high underlying leverage and poor lender flexibility in credit documentation.” “Continued valuation volatility and/or an increase in realized losses in 2023 could put pressure on asset coverage cushions for BDCs, particularly those leveraged at or above the high end of their target ranges,” Fitch added.
Fitch’s analysts aren’t the only ones expressing concern. Neil Unmack and Jonathan Gilford wrote for Reuters last month that BDC’s stock “traded at a 12% discount to their stated net asset value in early December, implying losses down the line.” Jason Friedman, global head of business development at Marathon Asset Management, also told Reuters recently, “Some of these [private lender/BDC] Companies — especially in the middle-market space — will face real difficulties, especially if there is not, as the market expects, a shallow recession.”
Whether Ares is equipped to weather these headwinds remains to be seen. But it goes without saying that at least part of Ares Capital’s recent dividend hike reflects growing investor concern about its near future.
Too good to be true? That’s not quite the right question.
Investors considering a new position in Ares Capital should understand that neither the market’s worst-case scenario nor its best-case scenario ever materializes. Company probably will A headwind of a credit crunch stemming from high interest rates and economic weakness. Company will also, however, is likely to continue collecting the bulk of outstanding interest payments anyway simply because its portfolio is comprised of viable businesses and economic downturns. Only time will tell how — and how much — these tensions will push stocks
What we do know now is that even if part of the stock’s recent dividend is paid out in 2023, its current 10.3% yield still makes it one of the income-producing bets for an uncertain time.