Ares Capital Fell Enough to Push Its Yield Near 10%. Here's the Number That Actually Worries Me.

Shares of Ares Capital (NASDAQ:ARCC) have fallen about 10% from their 52-week high ($22.51) to their current level of around $20 per share. That has pushed its dividend yield up near 10% (recently around 9.6%). Several factors have driven the slump, including rising interest rates, Ares' falling core earnings, and an uptick in non-accruals. That last number worries me a bit because it relies on receiving interest payments to pay its high-yielding dividend.

While the trend in non-accruals is concerning, it's not a major red flag yet, just something I plan to keep an eye on. Here's why it wouldn't make me sell the high-yielding business development company (BDC) stock just yet.

Image source: Getty Images.

Why a rise in non-accruals is slightly worrisome

Ares Capital noted in its second-quarter report that loans on non-accrual status represented 2.4% of its total investments at amortized cost (or 1.4% at fair value). That's up from 2.1% after the company added four loans to the non-accrual list during the quarter. That's a concern because a rise in non-accrual loans can indicate early stress in an underlying loan portfolio. If this trend continues, it could put the dividend at risk.

On a more positive note, the company highlighted on the quarterly conference call that these four new non-accrual loans were from companies operating in different industries and were unrelated to one another. CEO Kort Schnabel commented on the call that "We are not able to discern any trends yet around certain industries that are experiencing any kind of outsized weakness or leading us down this path toward more credit normalization."

Meanwhile, President Jim Miller highlighted on the call that its non-accrual rate was still below its historical average of 3% since the global financial crisis. Further, it remains well below the historical average of BDCs, which has been around 4% during this time frame. However, Miller did repeat his warning on the call that while the company has been operating in an extended period of lower non-accrual rates and defaults, "we think there is a reversion toward the mean there." This suggests this concerning trend will continue.

Why I'm not concerned enough to sell

While a rising non-accrual rate is somewhat troubling, Ares Capital has a strong track record of navigating the ebbs and flows of the credit market. It's the biggest BDC with a $29.3 billion investment portfolio spread across 619 portfolio companies. Its top 10 investments represent 10.5% of its portfolio at fair value, more than half the concentration of its BDC peers (22.2%). That diversification helps reduce risk. Further, it has an excellent investment record. Throughout its 21-year history, realized gains have outpaced losses by over $1 billion, averaging about 1% per year. That has helped support its 17-year track record of delivering a stable-to-growing dividend.

Those gains have given it a bigger cushion to support its dividend than its core earnings suggest. Ares Capital's core earnings of $0.94 per share through the first half of this year were down from $1.00 per share in the year-ago period. That put them below its dividend payments of $0.96 per share. However, it has recorded an additional $0.15 per share of net realized gains over the last 12 months, providing further support for the dividend. That has added to the gains it has banked over the years. It currently has $1.38 per share of taxable spillover income it carried forward from last year for distribution in future periods.

Here's what would worry me enough to sell

While this quarter's uptick in non-accruals is slightly troublesome, I'm not concerned enough to sell. It's still below the company's historical average. Further, Ares has a strong record of delivering realized gains, which has supported 17 years of dividend stability. That's why I'd continue to buy shares of Ares Capital for its high-yielding dividend. It's still a relatively small position for me, and I'd like to continue building it to grow my passive income.

However, what would really start worrying me is if its non-accruals surpass its historical average. That would likely lead to a larger dip in core earnings and require the company to use more of its cushion. If the dividend ever looked at risk, I'd consider selling Ares and reinvesting the proceeds into a higher-quality, high-yielding dividend stock.

Matt DiLallo has positions in Ares Capital. The Motley Fool has positions in and recommends Ares Capital. The Motley Fool has a disclosure policy.