Ares Capital Corp.: This 9.5%-Yielding BDC Is Worth Buying

Summary

• I bought Ares Capital Corp. for my income portfolio in April.
• Ares Capital Corp. has strong underwriting practices reflected in low non-accruals, and a debt investment portfolio that accentuates capital preservation.
• Ares Capital Corp. has interest rate upside thanks to a large representation of floating-rate debt in its investment portfolio.
• Ares Capital Corp. has maintained its dividend rate throughout the credit cycle. Shares currently sell for about net asset value.
• An investment in ARCC yields 9.5 percent.

I have added business development company Ares Capital Corp. (NASDAQ:ARCC), one of the largest BDCs in the country, to my high-yield income portfolio at the end of last month. The business development company has paid a stable dividend for years, and about covers its payout with net investment income. The portfolio consists largely of relatively secure first and second lien debt, which should provide income investors with some downside protection in the event of a recession. Shares are selling for about net asset value. An investment in Ares Capital Corp. currently yields 9.5 percent.

I bought a couple of business development companies for my income portfolio again in 2018, including Goldman Sachs BDC (GSBD), Hercules Capital, Inc. (HTGC), Main Street Capital Corp. (MAIN), and, yes, Ares Capital Corp. The reason: Ares Capital Corp. has a strong loan portfolio and low non-accruals, and has a robust history of making reliable dividend payments to shareholders.

Ares Capital Corp. - A High-Quality BDC Worth Considering

Ares Capital Corp. predominantly invests in relatively safe first and second lien senior secured loans. Together, they accounted for 72 percent of the BDC's investment portfolio at the end of the first quarter. Subordinated loans, collateralized loan obligations and equity securities made up the remainder of Ares Capital Corp.'s portfolio. The higher the degree of seniority, the higher the degree of principal protection for Ares Capital Corp. and its shareholders. Hence, Ares Capital Corp. is rather defensively positioned in terms of its asset allocation.

Here's a breakdown of Ares Capital Corp.'s investment portfolio as of the end of the March quarter.

Source: Ares Capital Corp. Investor Presentation

As far as industry diversification is concerned, I'd say that Ares Capital Corp. has a moderate degree of diversification. The BDC has a concentration in healthcare and business services which together represent 42 percent of the BDC's investments. The remainder of the portfolio, however, is quite diversified.

Source: Ares Capital Corp.

Strong Direct Origination Platform And Low Non-Accruals

Ares Capital Corp. has a strong, global origination platform and the company has been highly selective when it comes to closing deals. In 2017, Ares Capital Corp. closed just about 4 percent of its reviewed deals, selecting only the best credit risks for its investment portfolio.

Source: Ares Capital Corp.

Ares Capital Corp.'s selectivity when it comes to making investments is paying off for the company and its shareholders. An indication of this is that the BDC has had a very low amount of non-accruals over time (non-accruals on a fair value basis stood at just 1 percent of portfolio value at the end of the first quarter).

Source: Ares Capital Corp.

Don't Forget About Positive Interest Rate Sensitivity

Ares Capital Corp. has considerable interest rate upside tied to its large floating-rate portion of its debt investment portfolio. At the end of the first quarter, 79 percent of its debt investments (measured at fair value) were floating rate. The company's new investment commitments were even 100 percent floating rate which adds to Ares Capital Corp.'s appeal as an income play with interest rate and capital upside.

Source: Ares Capital Corp.

Dividend Coverage

The BDC just reported Q1-2018 results which included $0.39/share in core EPS and $0.34/share in net investment income. From a NII perspective, Ares Capital Corp. underearned its dividend by $0.04/share.

However, Ares Capital Corp. also said that it estimated "that it has carried forward excess taxable income of approximately $346 million or $0.81 per share from 2017 for distribution to stockholders in 2018". In other words, the company has enough excess taxable income to keep paying shareholders a stable dividend.

As far as net investment income is concerned, however, Ares Capital Corp. has not the best dividend coverage stats. Nevertheless, they are good enough to suggest that the BDC will be able to maintain its current dividend payout.

Source: Achilles Research

Ares Capital Corp. has paid shareholders a stable $0.38/share quarterly cash dividend since the third quarter of 2012, which is impressive considering how many BDCs/high-yield income vehicles have slashed their payouts in the last several years. Occasionally, management has even opted to distribute excess income to shareholders in the form of special dividends.

Source: Ares Capital Corp.

Selling For About Net Asset Value

Ares Capital Corp.'s defensive loan portfolio, low non-accruals, and excellent dividend history are good reasons to consider ARCC for a high-yield income portfolio, even though shares sell for about net asset value.

Main Street Capital Corp., by far, is the most richly valued BDC in the sector while a lot of major BDCs are priced at a discount to their respective net asset values.

Ares Capital Corp.'s shares, in my view, are close to being fairly valued. Higher interest rates and higher net interest income from its debt investments could be a positive catalyst for Ares Capital Corp.'s share price, though.

ARCC Price to Book Value data by YCharts

Your Takeaway

I like Ares Capital Corp. as a relatively secure income play. Though a near ten percent dividend yield is never really "safe", Ares Capital Corp. has demonstrated that it can pay a stable dividend throughout the economic cycle, which I think greatly enhances its investment proposition. Though shares aren't exactly cheap - I normally like to buy BDCs at a 10 percent or higher discount to NAV - Ares Capital Corp. is a solid BDC income play with a strong loan portfolio, low non-accruals, good dividend coverage (on average) and interest rate upside.

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Analyst’s Disclosure: I am/we are long ARCC, MAIN, HTGC, GSBD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.