A Perfect Gift For Your Children: Ares Capital’s 9.6% Yield (NASDAQ:ARCC)

Ares Capital (NASDAQ:ARCC) has, in my opinion, one of the best and safest BDC dividend yields in the entire sector that passive income investors can buy for themselves or their children.

Ares Capital paid its dividend with net investment income in the fourth quarter, and despite the fact that the business development company’s stock is now trading at a premium to net asset value, I’m happy to have Ares Capital in my passive income portfolio.

Furthermore, amid a strong labor market, the central bank may continue to raise interest rates at a rapid pace in 2023, which will benefit Ares Capital’s heavily floating rate investment portfolio.

Senior Secured Loan-Focused Investment Portfolio With Good Portfolio Quality

Ares Capital’s investment portfolio underwent no significant changes in the fourth quarter. Senior Secured Loans are still heavily overweight at the business development firm.

As of December 31, 2022, First Lien Senior Secured Loans accounted for 43% of the BDC’s investment portfolio vs. 45% in the third quarter. Second Lien Senior Secured Loans accounted for 18% of total investments, remaining unchanged from the previous quarter.

Ares Capital has a safe and diverse investment portfolio to offer passive income investors, with 61% of assets invested in Senior Secured Loans.

Ares Capital experienced an increase in non-accruals in the most recent quarter, prompting the BDC to raise its non-accrual ratio to 1.1%, a 0.2 percentage point increase QoQ. With the increase in non-accruals, the total amount of troubled investments now stands at $241 million. Despite an increase in non-accruals, portfolio quality remained stable.

Dividend Coverage

Ares Capital had net investment income of $0.68 per share in the fourth quarter, and the business development company paid out its new $0.48 per share dividend for the first time.

Despite the increased dividend, Ares Capital’s dividend pay-out ratio dropped 4 percentage points QoQ to 71%. The decrease in the pay-out ratio is due to Ares Capital’s investment portfolio’s exceptional performance in a rising-rate environment.

In 2022, the total pay-out ratio was only 80%, which is excellent for a business development firm. Many BDCs have much higher pay-out ratios and provide investors with less diversification than Ares Capital does.

Floating Rate Exposure

Aside from strong dividend coverage and a high yield, one of the best reasons to own ARCC is the BDC’s floating rate exposure, which I discussed here.

As of December 31, 2022, 71% of Ares Capital’s portfolio was invested in floating rate debt, providing ARCC with significant income upside in a rising-rate environment.

Since the job market experienced a blockbuster jobs report in January, with 517K new payrolls, the central bank has a strong case to continue raising interest rates, pointing to both net investment income and dividend growth.

9% Premium To Net Asset Value

Ares Capital is once again trading at a 9% premium to book value, as evidenced by the BDC’s fourth-quarter and full-year results.

Ares Capital’s floating rate debt portfolio provides great dividend coverage, decent portfolio quality, and portfolio income upside, and passive income investors are willing to pay for a competent investment manager.

Why Ares Capital Could See A Lower/Higher Valuation

Ares Capital’s credit quality is not currently concerning, but this could change in the future if the business development company encounters economic headwinds that result in an increase in non-accruals.

Furthermore, Ares Capital has significant exposure to floating rate interest rates, and a strong labor market is currently supporting the central bank’s policy of continuing to raise interest rates.

However, a slower pace of rate hikes in 2023 and interest rate cuts would likely be a drag on Ares Capital’s portfolio income growth, which is tied to the BDC’s floating rate debt investments.

My Conclusion

Ares Capital remains one of the best BDCs available for passive income investors to purchase for themselves or their children.

In the fourth quarter, the business development company’s dividend was covered by net investment income, indicating that it is well-managed. The dividend has room to grow, according to the 80% pay-out ratio for 2022, which you (or your children) will appreciate.

Despite the fact that Ares Capital’s stock is once again trading at a premium to net asset value, the company’s large, diversified debt portfolio, floating rate exposure, and strong dividend coverage ratio make it a BDC with a very reliable 9.6% dividend yield.

Ares Capital is a long-term investment in which I hope never to have to sell.