Little-Known Stock with a Big Payout
Most people have never heard of Ares Capital Corporation (NASDAQ:ARCC). But if you are an income investor looking to boost the return of your dividend portfolio, then this company deserves your attention.
Here’s why.
ARCC Stock Pays Generous Dividends
With the prolonged bull market, valuations have soared through the roof. And one of the by-products of surging share prices is subdued dividend yields. Historically, the S&P 500 Index had an average dividend yield of almost 4.4%. Today, the average S&P 500 company pays just 1.8%. (Source: “S&P 500 Dividend Yield,” Multpl.com, last accessed August 6, 2018.)
And that brings us to the first reason to like Ares Capital Corporation—the sheer size of its payout.
Ares Capital Corporation is a specialty finance firm that invests primarily in middle-market companies in the United States. Most of its investments are in senior secured loans, so the company can earn a predictable interest income stream. And since Ares Capital chooses to be regulated as a business development company (BDC), it is required by law to distribute at least 90% of its profits to shareholders in the form of dividends.
Last week, the company raised its quarterly dividend rate by 2.6% to $0.39 per share. At the current share price, that gives ARCC stock an attractive annual yield of 9.1%.
Solid Dividend Coverage
Of course, if you use any of the stock screeners available on the Internet these days, you can easily find companies with even higher yields. However, most of them aren’t really safe bets for income investors, due to their dividend safety—or rather, the lack of it. What makes Ares Capital stand out is that, despite being an ultra-high yielder, the company actually makes enough money to cover its payout.
You see, Ares Capital provides financing solutions to middle-market businesses, which can’t always get loans from large banks. As a result, middle-market companies often have to pay higher financing costs. To Ares Capital, that has translated to oversized interest income.
As of June 30, the company’s weighted average yield of debt and other income-producing securities at amortized cost stood at 10.4%. (Source: “Ares Capital Corporation Declares Third Quarter 2018 Dividend of $0.39 Per Share, And Announces June 30, 2018 Financial Results,” Ares Capital Corporation, August 1, 2018.)
And that’s basically how Ares Capital can afford to have such a generous dividend policy. The company reported earnings last week. In the second quarter of 2018, ARCC generated core earnings of $0.39 per share, which was more than enough to cover its quarterly dividend payment of $0.38 per share.
In the first half of 2018, Ares Capital’s core earnings came in at $0.78 per share. Again, the amount provided ample coverage for its total dividends of $0.76 per share declared and paid during this period.
Rising Interest Rates
And if you think the company’s current dividend coverage ratio does not leave a wide enough margin of safety, don’t worry. Going forward, Ares Capital could capitalize on a major catalyst—the rising interest rate environment.
Interest rates have been rising for quite some time. While the U.S. Federal Reserve kept its benchmark rate constant at last week’s meeting, it has hinted at a rate hike in September. Knowing that interest rates are going up, Ares Capital has been investing primarily in floating rate loans.
By the end of the second quarter of 2018, 78% of the company’s total investments by fair value bore interest at floating rates. On the liabilities side, nearly all of its debt is fixed rate. Therefore, if interest rates go up, Ares Capital could earn higher interest income without incurring much higher interest expense. That would lead to an increase in the company’s bottom line. (Source: “Second Quarter 2018 Earnings Presentation,” Ares Capital Corp, last accessed August 6, 2018.)
In fact, in the company’s latest 10-Q filing to the U.S. Securities and Exchange Commission (SEC), management actually quantified how much of an increase that would be. They estimated that, if the benchmark interest rates rise by 100 basis points, Ares Capital would earn an extra $88.0 million in annual net income. And if benchmark rates go up by 200 basis points, the increase in the company’s bottom line would be $178.0 million. (Source: “Form 10-Q,” U.S. Securities and Exchange Commission, last accessed August 3, 2018.)
Final Thoughts on Ares Capital Corporation
At the end of the day, keep in mind that Ares Capital’s generous dividends are backed by a pretty solid business. As of June 30, ARCC had an $11.5-billion portfolio diversified across 346 different companies. First and second lien secured loans comprised 70% of the company’s total portfolio fair value.
Add it all up and you’ll see that Ares Capital is one of the few nine-percent-plus yielders that are actually worth considering right now.