Ares Capital: I Am Getting A 10.6% Yield On My Last Buy (NASDAQ:ARCC)

The market price of Ares Capital Corporation (NASDAQ:ARCC) fell below net asset value at the end of last week, and I received a 10.6% dividend yield on my most recent purchase.

ARCC trading below NAV, in my opinion, lowers the risk profile for passive income investors. Because the business development company (“BDC”) is exposed to floating rate interest rates, investors don’t want to miss out on buying ARCC’s covered 10.6% dividend yield on the drop.

Buy The Drop

Passive income investors now have the opportunity to purchase one of the world’s best credit managers and debt investors at a discount to net asset value. BDCs, such as Ares Capital, typically sell at a premium to net asset value. However, if a discount valuation occurs, passive income investors should not pass up the opportunity to invest.

As I write this, Ares Capital’s stock has fallen to $18.17, implying that the BDC can be purchased at a 2% discount to net asset value. I generally prefer to acquire high-quality business development companies at a discount to net asset value, preferably those with a track record of sound credit and investment decisions.

Ares Capital Is An Experienced Credit Manager With Historically Low Loan Losses

Ares Capital primarily invests in First and Second Lien Senior Secured Loans, which accounted for 68% of the company’s investments at the end of the third quarter. The majority of company investments flow into sectors with stable cash flow profiles that are not subject to the economy’s cyclical swings, such as software or healthcare.

As one of the world’s leading debt managers, Ares Capital has extensive credit management experience, which has resulted in exceptionally low loan losses.

Despite more than $58 billion in capital provided to companies, the net realized loss rate, which represents actual loan losses, has been exceptionally low. Ares Capital also outperformed both its BDC peers and banks in terms of realized loss rate.

Floating Rate Exposure

The central bank raised interest rates again in December, this time by 50 basis points, adding to a series of four 75-basis-point hikes in 2022. The new interest rate range is 4.25% to 4.50%, and the market expects rates to rise as long as inflation remains a source of concern for investors and consumers.

Ares Capital Is Positioned To Benefit From Rising Interest Rates

The debt portfolio of the business development company is heavily weighted toward floating rate loans, with 87% of loans resetting rates if the central bank raises interest rates.

Moving forward, the earnings impact of higher interest rates could be quite significant, with a 200-basis-point increase in base rates expected to result in a 23% increase in core earnings.

Why Ares Capital Could See A Lower Valuation

The risk profile of Ares Capital is directly related to the quality of its underlying debt instruments. The risk profile remains moderately low as long as credit (LOAN) quality remains high.

Having said that, an increase in the number of borrowers defaulting on their obligations to Ares Capital would be a major cause for concern and would most likely result in a larger net asset value discount in the future.

Ares Capital’s historically low loss ratios lead me to believe that ARCC is the best credit manager available to passive income investors.

A 10.6% Yield!

Ares Capital pays a quarterly dividend of $0.48 per share, yielding roughly a 10.6% dividend yield. The BDC had a payout ratio of 75% in 3Q-22, so its dividend was easily covered by net investment income. Because of the low payout ratio, special dividends can be paid.

My Conclusion

This week, I purchased more Ares Capital at a 2% discount to net asset value. On my most recent purchase, I received a 10.5% dividend yield, and the dividend was covered by net investment income.

Given the 2% discount to net asset value, I believe Ares Capital’s significant exposure to floating rate investment debt makes this a good bargain for me and potentially other passive income investors as well.

Because Ares Capital has previously demonstrated its worth by delivering industry-beating loan losses, I recommend ARCC to passive income investors seeking to generate growing and predictable dividend income from one of the market’s most competently managed business development companies.