Ares Capital: the safest dividend has just been raised (NASDAQ:ARCC)

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The recent rise in bond yields has some thinking that the 60/40 rule of allocating 60% to stocks and 40% to bonds is back. I would say though that this allocation methodology is still designed for mediocre returns, given that stubbornly high inflation would eat away at most of the income from the bond portion of the portfolio.

That’s why I think a safe income-generating stock portfolio is the best bet for anyone looking for a growing stream of income to cover day-to-day expenses, whether you’re retired, starting your career or in your best working years.

This brings me to Ares Capital (NASDAQ: ARCC), which remains attractive, especially after the recent decline due to its capital increase. In this article, I outline what makes ARCC a good growing income stock to buy on a downside, so let’s get started.

Why ARC?

Ares Capital is the largest BDC in terms of asset size and is externally managed by highly respected Ares Management (ARES), a leading alternative asset manager operating in credit, real estate and investment capital. It was founded 18 years ago and currently holds an investment portfolio of $21.2 billion at fair value, spread across 452 different holding companies.

ARCC’s portfolio is well balanced, with approximately two-thirds comprised of senior secured loans (45% first lien, 19% second lien) and the remainder comprised of higher yielding subordinated loans, equity preferred and common stock for an engine of growth. Notably, ARCC is also invested in another asset manager, Ivy Hill Asset Management, whose chairman is affiliated with ARCC. As shown below, ARCC’s investment portfolio is geared towards growth and defensive sectors, with software and services, healthcare and business services being its top 3 sectors.

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Composition of the ARCC portfolio (Ares Capital)

ARCC just reported strong second quarter results, with core EPS of $0.46 beating the consensus estimate of $0.02 and rising 9.5% year-on-year from $0.42 the last year. This is due to the benefits of rising rates, higher dividends from its portfolio companies, and credit stability within its portfolio.

Notably, the net asset value per share fell 1% year-over-year to $18.81. I’m not too worried though, as this was due to market volatility and economic uncertainty, which led to wider credit spreads between corporate bonds and US Treasuries. This results in lower valuations on the principal of the loan, as investors expect to earn a higher return by taking on more risk.

Meanwhile, his investment portfolio remains stable, with only 1 new loan added to non-accumulated status during the second quarter. Its total unrecognized expenses represent 1.6% of the cost of the portfolio, well below the ARCC’s 10-year average of 2.5%. As shown below, the credit quality of ARCC’s portfolio has improved over the past year, with significant movement between the grade 2 and grade 3 segments (the higher the better).

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Quality of the ARCC portfolio (Ares Capital)

Going forward, the ARCC should benefit from rising rates, as 74% of its debt investments are floating rate. Rising rates have benefited ARCC’s debt-weighted average yield, which currently stands at 9.5%, compared to 9.0% in the prior year period. It also keeps plenty of dry powder to fund its pipeline, with $4.6 billion in total cash on hand, and the balance sheet remains strong with a debt-equity ratio of 125%, comfortably below the statutory limit of 200%. .

Management expressed the opportunity presented by rising rates and the ability of portfolio companies to sustain higher interest payments, as noted on the conference call:

We believe that the continued rise in market interest rates presents a potential opportunity for growth in our core earnings given our broadly variable rate loan portfolio and is funded primarily by low cost, interest rate sources of funding. fixed and not guaranteed. If the full impact of the market rate movements this quarter had rippled through our entire quarter, we calculate that our second quarter core earnings could have been approximately 11% higher based on the rate of ‘execution.

Additionally, if market rates were to rise 100 basis points from June 30 levels, our quarterly core earnings could benefit by approximately $0.08 per share or a 17% increase over our earnings. baseline for the second trimester. We believe the earnings benefits of these market rate increases will have more impact in the third quarter and beyond.

We also do not believe that the currently projected rate hike will cause credit performance to deteriorate. All other things being equal, including leverage at the borrower level, a 150 basis point increase in market rates would result in a weighted average interest coverage ratio in the portfolio of approximately twice . It is important to note that this analysis does not take into account the growth in EBITDA or the deleveraging that has historically occurred in the portfolio.

Meanwhile, the ARCC recently rewarded shareholders with a 2.4% dividend increase to $0.43 per share, resulting in a dividend yield of 8.9%. Additionally, ARCC is currently paying a special dividend of $0.03 per quarter, bringing the yield to 9.5%. The regular dividend is also well covered by Q2 core EPS of $0.46.

I see value in the ARCC, especially after its fall following the announcement of the capital increase. Currently, it has a price-to-book ratio of 1.03x. As seen below, the ARCC has generally traded in the 1.1-1.2x range for the past 3 years, outside of periods of deep discounts.

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ARCC Price-to-Book (Seek Alpha)

Key takeaway for investors

Ares Capital Corporation is a high quality BDC that is well positioned to take advantage of rising rates. It has a solid portfolio, abundant liquidity and a strong balance sheet. The dividend is also well covered and offers a high yield. I think the recent capital increase announcement has created an opportunity for investors to buy ARCC at a price below historical valuations.

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