Dividend stocks are an excellent way for investors to generate passive income. However, not all dividend stocks are the same. Some companies have a modest but steady dividend payout that grows over time. Other companies pay out jaw-dropping yields that far outpace what you could earn from a Treasury bond.
Ares Capital Corporation (NASDAQ: ARCC) is an ultra-high-yielding dividend stock, with a yield of nearly 9.5%. Its yield is attractive, and the stock has delivered market-beating returns since its inception in 2004. Here's what you should know about Ares Capital and why it is a solid dividend stock to buy today.
Ares Capital Corporation fills a big hole left by banks
Ares Capital Corporation is a business development corporation (BDC) that provides financing to middle-market companies. It does this by investing in debt or equity to companies with earnings before interest, taxes, depreciation, and amortization (EBITDA) between $10 million and $250 million.
BDCs appeal to dividend-focused investors because of their tax structure, which allows them to avoid paying income taxes as long as they distribute 90% of their taxable income to investors. For this reason, the average BDC pays a lofty dividend yield compared to most other dividend-paying stocks.
With over $10.8 billion in net assets, Ares Capital Corporation is the largest publicly traded BDC in the U.S. and fills a need left behind by traditional banks. That's because banks have shifted away from extending senior secured loans to middle-market companies in favor of larger companies, whose debt is more liquid and considered to be less risky.
According to data from PitchBook, banks went from around a 70% share of the middle market direct lending market in 1994 to around 25% in 2022. Their retreat from lending to this sector has created a huge opportunity for BDCs like Ares Capital.
Image source: Ares Capital Corporation.
Investors should consider these risks before investing in BDCs
BDCs can make solid investments for dividend-focused investors. However, lending to middle-market companies comes with its own risk. BDCs use leverage to boost their payouts to shareholders, which could exacerbate losses in a poor economic environment. The debt-to-equity ratio is one measure of how much leverage a BDC uses. Ares Capital's debt-to-equity of 1.03 is below the industry average of 1.08, showing the company's conservative use of leverage.
Middle-market loans are also less liquid, meaning companies that have to sell these assets may be unable to sell them quickly in a crunch. These loans could also be vulnerable to economic downturns, as borrowers may struggle to generate cash flows to pay their debts.
Bearing those risks in mind, Ares Capital has managed to mitigate its risk well. For example, 60% of its loans are first-lien or second-lien senior secured loans -- making it one of the first creditors paid off in a liquidation event.
Ares also spreads its loans across 34 different industries. That's more than its peers, which spread across 26 industries on average. Ares also avoids highly cyclical businesses that could be more vulnerable to economic downturns, including hotel and gaming, oil and gas, transportation such as airlines, and media and entertainment.
Ares has an established history of navigating challenging times
Ares Capital is a strong performer that has navigated multiple recessions since its inception in 2004. This includes the Great Recession in 2008-2009, when defaults on leveraged loans topped 10%, and the pandemic-induced recession of 2020. This stellar long-term performance is a testament to the company's ability to manage risk across different credit cycles.
ARCC Total Return Level data by YCharts
Investors should keep an eye on the health of the economy, which could affect the borrowers Ares Capital lends to. However, the company's track record of stellar risk management and the ongoing opportunity to fill the funding gap to middle-market companies left behind by banks make this a stellar ultra-high-yield dividend stock you can buy today.
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Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
