Is This 8.7% Yield Too Good to Be True?

Income investors love business development companies (BDCs) because of their high yields.

BDCs lend money to businesses that are unable to receive funding from banks. But these aren’t sketchy operations like the one your brother-in-law is trying to run where he just needs $20,000 for the next couple of weeks.

These are real businesses that are often cash flow positive but perhaps lack a long enough credit history to borrow from traditional lenders.

My BDC of choice is Ares Capital Corp. (Nasdaq: ARCC), which is currently recommended in the High Yield Portfolio in The Oxford Income Letter.

Ares Capital pays a $0.45 per share quarterly dividend, which it just raised from $0.41. That gives the stock an impressive 8.7% yield. Can investors rely on the dividend going forward?

Yes and no.

Technically, the quarterly dividend is $0.42 per share with a $0.03 per share special dividend expected to be paid in each quarter of 2022. Management has not stated its plans on what will happen to the special dividend in 2023. In spite of that, Ares has a history of paying special dividends. It paid one in 2014, 2015 and 2016 and several in 2020, among others.

Looking at the financials, we can see that in 2021, Ares generated $741 million in net investment income (this is the amount of money the company makes from its investments). Ares paid out $691 million in dividends, so it was able to afford the dividend in 2021.

But that net investment income figure for 2021 was down from $791 million in 2020. Safety Net doesn’t like to see negative growth on net investment income (or any measure of cash flow for a dividend-paying company). So Ares’ dividend safety rating gets penalized for the lower number in 2021.

There are no net investment income estimates for 2022, but revenue and operating profit are forecast to grow 8% and 23%, respectively.

Let’s be conservative and assume that net investment income grows by 8%. If that’s the case, net investment income would total $800 million. A $0.45 per share quarterly dividend would equal $803 million in dividends paid – a figure that’s pretty much right where net investment income should come in.

If we look at that $0.03 per share special dividend as truly a special dividend for this year and don’t assume it’s part of the quarterly payout, then the $0.42 per share quarterly dividend equals $750 million. So pretty much any increase in net investment income should easily cover the dividend.

Investors can feel relatively secure that their $0.42 per share quarterly dividend is safe. However, they shouldn’t necessarily feel the same way about the extra $0.03. It all depends on where net investment income comes in at the end of the year.

Dividend Safety Rating: B

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