Should You Buy Ares Capital Corporation Stock While It's Below $21?

Over the past few decades, banks have stepped back from lending to specific segments of the economy, creating a massive opportunity for business development companies like Ares Capital Corporation (NASDAQ: ARCC). The company lends to middle-market companies and is an appealing stock for investors seeking passive income, thanks to its 9.3% dividend yield.

However, private credit has come under scrutiny amid the failures of troubled borrowers like First Brands and Tricolor, which have highlighted some of the risks of lending to mid-sized companies. Investors grew more concerned when JPMorgan Chase CEO Jamie Dimon said, "When you see one cockroach, there's probably more."

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Ares Capital Corporation's stock is 14% below its 52-week high and is priced under $21 per share. Is that enough to make it a buy today? Let's dive into the business and the evolving landscape to find out.

Ares Capital Corporation offers an attractive dividend

Ares Capital Corporation operates the largest business development company (BDC) in the United States. It primarily lends to middle-market businesses at high interest rates. As a BDC, Ares Capital is required to distribute 90% of its taxable income to its investors, making its nearly 9% dividend yield highly attractive to those seeking passive income.

Many of its loans have floating rates, so its earnings are closely tied to interest rates and the changes around them. When rates fall, its interest income declines, putting pressure on net investment income and potentially impacting its dividend payout. It employs hedging strategies that mitigate some of this downside, but a rate-cut cycle could still erode earnings. As a result, Ares Capital tends to be more attractive in stable or rising interest rate environments.

Monitoring recent news in the credit markets

One key risk for investors in BDCs is the credit quality of the underlying assets. Ares Capital lends to companies that often lack access to traditional financing, making them riskier borrowers. In economic downturns, these mid-sized companies are more vulnerable to distress and default. A spike in defaults would impact Ares Capital's income and book value, potentially leading to a reduction in its dividend payout.

Recently, investors have become concerned about credit quality amid the high-profile defaults of private companies such as First Brands and Tricolor. First Brands, an auto-parts company, and Tricolor, a used-car retailer and lender, both took on sizable private credit financing during the era of cheap money. The collapse of these two companies raised concerns about opaque financing practices by some private companies and the stability of certain credit markets.

Ares Capital has no exposure to First Brands or Tricolor. It also has no exposure to non-prime consumer finance firms, like Tricolor. However, following events at First Brands, management was asked about portfolio companies' use of receivables financing and whether it posed "any hidden risks."

Management responded that they do not believe there are hidden risks in their portfolio due to thorough due diligence on any receivables financing arrangement, vetting of the broader capital structure, and requiring that any such financing remaining post-closing be subject to strict monitoring.

Ares Capital draws on a management team with a long history of lending to middle-market companies, dating back to 2004. The company has a diversified portfolio of over 587 companies across sectors, helping it spread out risk. Meanwhile, 61% of its loans are first lien, meaning it gets priority to be paid first if a borrower runs into trouble. As of Sept. 30, only 3.6% of its investments are performing below expectations, a slight uptick from Dec. 30, when 2.9% were at this level.

Is Ares Capital Corporation stock right for you?

Ares Capital Corporation has a long history of lending to middle-market companies and a strong track record in this niche. That said, it faces headwinds from a further decline in short-term interest rates, which could affect its near-term earnings.

CEO Kort Schnabel noted that the company is in a position to maintain its current dividend payout for the "foreseeable future," as its payout has been set at a conservative level while core earnings exceed the dividend payment.

If you're concerned about declining interest rates and the prospect of a recession, which could impact Ares Capital's borrowers, then this stock isn't for you. However, if you think the economy holds up and interest rates don't decline too much from here, Ares Capital is an attractively priced stock you can scoop up today right around book value.

JPMorgan Chase is an advertising partner of Motley Fool Money. Courtney Carlsen has positions in JPMorgan Chase. The Motley Fool has positions in and recommends Ares Capital and JPMorgan Chase. The Motley Fool has a disclosure policy.