The Fed Will Keep Hiking, Our Income Keeps Growing

Sep. 07, 2022 6:35 AM ETACRE, ARCC, ARES79 Comments

Summary

  • Rate hikes are coming and will not stop until the Fed thinks it has beaten what it first denied existed - persistent inflation.
  • Debt keeps getting more expensive; it's best to be owed than to owe.
  • We look at two opportunities with yields up to 10%.
  • Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Learn More »

Jerome Powell Testifies Before House Committee On Financial Services

Win McNamee/Getty Images News

Co-produced with Treading Softly

It wasn't long ago that many thought the Federal Reserve was missing the point on inflation and was moving too slowly. We agreed.

Not to be outdone in their latest pattern of failure, the Federal Reserve is now actively overshooting the need to raise rates. Inflation is tapering off on its own, without the need for raising rates any further. Yet it seems as determined to keep hiking rates as it was to hold on to the "inflation is transitory" narrative.

Jerome Powell is now likely a household name. He has certainly been a key catalyst for the stock market. The Federal Reserve Chairman expressed that the economy will be in for pain in the future as the Fed goes all in on beating down inflation. It's like a police officer shooting blindly at a criminal and forgetting the risk to innocent bystanders.

So the drumbeat of raising interest rates will continue, even though the Fed knows it will damage the economy. As investors, we need to recognize this reality. When rates are climbing, it is better to be the creditor who is owed money than the debtor who must repay it.

Today I have two excellent picks that are already pumping out large sums of cash for their shareholders. Why do I want to highlight them today? Because both of them are set to generate even more cash as rates rise. Every rate increase flows directly through their top line to their bottom line.

More bottom-line cash means more cash for you and me, especially when in a structure that must pay out the vast majority of its taxable revenue.

Let's dive in.

Pick #1: ARCC - Yield 9.2%

Ares Capital (ARCC) is one of the oldest and largest publicly traded BDCs (business development companies). For several reasons, we've been very bullish on BDCs for the past two years.

  • BDCs lend to "middle-market" companies. These are the businesses that make the U.S. economy tick and stood to gain the most from the COVID recovery.
  • Ultimately, most BDCs are "value" investors. They make debt/equity investments in companies based on current cash flows. The debt provides a predictable and consistent return, while the equity portion provides upside potential.
  • BDCs are much more flexible than banks at modifying agreements. BDCs approach companies as capital partners, with interest at various levels of the capital structure rather than just a lender. This made them uniquely positioned to be capital providers of choice during the COVID pandemic, where flexibility was everything.
  • As we exit the pandemic, we saw inflation and the likelihood of rising interest rates. BDCs borrow fixed-rate debt, and the loans they make are floating-rate. The best business plan for a rising rate environment.

Fast forward to today, and BDCs have been strong. Dramatically outperforming the S&P 500 over the past two years. ARCC has been especially strong and has hiked its regular dividend twice in 2022 while also paying a supplemental dividend.

With the Fed remaining on its hawkish warpath, committed to hiking, ARCC is well positioned to benefit directly from rising rates.

graphic

ARCC Q2 Investor Presentation

Every hike is more money to the bottom line for ARCC. Some worry that rising rates will put stress on companies with floating rate loans, and that we will see a recession if the Fed hikes too far.

A recession is a risk, and it is at the forefront of our minds at HDO. If I could hold only one BDC through a recession, it would be ARCC. Why? ARCC has been through the Great Financial Crisis, it has been through COVID, and through these adverse conditions has demonstrated impeccable underwriting quality.

ARCC's historical debt losses have been minimal. Meanwhile, the excess gains that ARCC has realized through things like restructuring, buyouts, and equity positions have exceeded any credit losses.

ARCC Q2 Investor Presentation

ARCC Q2 Investor Presentation

In short, ARCC has proven an ability to make lemonade when the market gives them lemons - turning borrowers at risk of default into larger profits. This is because ARCC brings a wealth of resources from Ares Management (ARES). They are more than just a lender, they are a capital provider that helps companies through tough times. Then the profits are passed along to us shareholders as dividends!

Pick #2: ACRE - Yield 10.8%

Ares Commercial Real Estate (ACRE) is another company that is managed by Ares Management. ACRE provides senior mortgages that are secured by commercial properties in institutional-level real estate transactions.

ACRE Presentation

ACRE Presentation

ACRE's loans are generally short-term, starting at 3 years with a few extension options available if the borrower maintains creditworthiness. This is where ACRE's relationship with ARES comes in handy. The game's name is to have new originations to make up for loans being repaid.

Even though COVID slammed on the brakes for the real estate market in 2020, ACRE maintained dividend coverage in 2020 and added a supplemental dividend in 2021.

graph

ACRE Presentation

ACRE continues to fire on all cylinders. Now, ACRE has another tailwind, and that is rising interest rates. ACRE's loans are primarily floating-rate, so as interest rates rise, their earnings go up.

chart

ACRE Presentation

The more the Fed hikes, the more ACRE makes. ACRE is a great option if you want to hedge your portfolio against rising rates.

Shutterstock

Shutterstock

Conclusion

While many view rising rates as the enemy to their portfolios, you can invest in opportunities to make rising rates your friend. This way, whenever you hear of the Fed hiking rates again, instead of being an innocent victim, you can be an active victor.

You can stand alongside us and cheer: "Go get 'em, Powell, beat that inflation back!" All the while, we will enjoy the growing levels of cash pouring into our retirement accounts and coffers.

I liken dividends to water flowing from point A to point B. Every investment you make that pays you dividends is another tributary pouring water into the main river. Every new dividend puts more cash flow raining into your retirement. Every dollar is an opportunity to be explored and a taste of financial freedom captured.

Dollars can be used to do whatever you want with them. Reinvest? Great! Horde for future emergencies? Good idea! Buy tickets to the game and grab a hotdog to boot? Awesome!

I want you to enjoy the taste of that freedom countless times every month. That's what income investing can do for you. Don't fight the Fed. Benefit from their decisions, whatever those might be. These are two opportunities to do so.

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This article was written by

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Disclosure: I/we have a beneficial long position in the shares of ACRE, ARCC either through stock ownership, options, or other derivatives. 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.

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