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

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

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

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

Investment portfolio focused on senior secured loans with good portfolio quality

Ares Capital’s investment portfolio did not undergo any significant changes during the fourth quarter. Senior Secured Loans are still heavily overweighted in the business development company.

As of December 31, 2022, Senior Secured Loans represented 43% of BDC’s investment portfolio compared to 45% in the third quarter. Senior Secured Second Lien Loans represented 18% of total investments, unchanged from the previous quarter.

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

Ares Capital has seen an increase in misses over the past quarter, prompting BDC to raise its miss ratio to 1.1%, an increase of 0.2 QoQ percentage points. With the increase in non-recognitions, the total amount of distressed investments now stands at $241 million. Despite an increase in defaults, the quality of the portfolio remained stable.

Dividend coverage

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

Despite the dividend increase, Ares Capital’s dividend payout ratio fell 4 QoQ percentage points to 71%. The lower payout ratio is due to the exceptional performance of Ares Capital’s investment portfolio in a rising rate environment.

In 2022, the total payout rate was only 80%, which is great for a business development company. Many BDCs have much higher payout ratios and offer investors less diversification than Ares Capital.

Floating rate exposure

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

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

Since the labor market saw a hit jobs report in January, with 517K new payrollsthe central bank has a strong case for continuing to raise interest rates, indicating both net investment income and dividend growth.

9% premium on net asset value

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

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

Why Ares Capital Might See a Lower/Higher Valuation

Ares Capital’s credit quality is not a concern at this time, but that could change in the future if the business development company encounters economic headwinds that result in increased defaults.

Additionally, Ares Capital has significant exposure to floating interest rates, and a strong labor market is currently supporting the central bank’s policy to continue raising interest rates.

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

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 for growth, depending on the payout rate of 80% for 2022, which you (or your children) will appreciate.

Despite the fact that Ares Capital shares are 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 dividend yield of 9.6%.

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