Is Ares Capital Stock a Buy Now?

The big attraction of Ares Capital (NASDAQ: ARCC) for most investors will be its lofty 8.9% dividend yield. That compares very favorably to the scant 1.2% you could collect from an S&P 500 index fund. Ares Capital's yield is high for a reason, which is why most investors should consider its business model very carefully before buying now or, frankly, at any time.

Here's what you need to know before you jump aboard.

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What does Ares Capital do?

Ares Capital is a business development company (BDC). This is a unique niche of the finance sector. Essentially, BDCs provide loans to small and medium-sized companies that can't access cash from other sources, like banks or the public markets, in a cost-effective manner. That's a huge statement to think about, since the weighted average yield on Ares Capital's investments was just shy of 10% at the end of the first quarter of 2025.

Image source: Getty Images.

Basically, the loans Ares Capital is making are expensive for the borrowers, but they are still among the best options available. Ares Capital is taking a risk with each investment, and so are investors who buy Ares Capital stock. The key for Ares Capital is that it has a diversified portfolio of investments. At the end of the first quarter, it had over 560 investments. The hope is that all the companies won't face financial hardship at the same time.

Of course, Ares Capital examines the companies before investing in them. On that score, Ares Capital is run by Ares Management (NYSE: ARES), a large alternative asset management company. So there is a fairly large team backing Ares Capital as it goes to work trying to find good investments. Another important factor here is that many of the loans Ares Capital makes are tied to market rates. So when rates rise, Ares Capital earns more in interest, though it earns less when rates fall, too.

From a big-picture perspective, Ares Capital is planting seeds in smaller companies with the hope that they'll grow into bigger ones. If it's right, it benefits from collecting an attractive yield until the company grows to the point where it can access funding at more attractive rates from other sources. It's not a bad business model, but it is one that comes with elevated risks for long-term dividend investors.

What could go wrong with Ares Capital?

While having the backing of Ares Management means that Ares Capital has a strong parent, it also means that the BDC is likely to invest in ways that appease Ares Management. So, if Ares Management is working with a small company, Ares Capital probably wouldn't be able to say no to giving that business a loan. Such conflicts of interest, which are discussed at length in the company's annual 10-K, could become an issue at the most difficult times.

That brings up the interest rates that Ares Capital charges. They are fairly high, which means any business adversity could quickly become a big problem for a borrower. A large portion of the loans have floating interest rates, which means that rising rates could quickly become a big problem, too. This means that a recession could lead to portfolio-wide problems -- and so could a strong economy, if the Federal Reserve dramatically increased interest rates to slow inflation.

Granted, the large and diversified portfolio should help to soften the blow from any individual loans that turn into a problem. But if large changes happen in the economy, even diversification may not be enough to help. Several once-prominent BDCs declared bankruptcy or had to sell themselves during the Great Recession of 2007-2009.

Data by YCharts.

To be fair, Ares Capital existed during the Great Recession and muddled through the difficult period, but its share price plunged, and it cut its dividend. The only other recession since that point was the short-lived recession during the coronavirus pandemic's height. So most of Ares Capital's existence has actually been during what could be called "good times." Long-term dividend investors should pay attention to what happened during the "bad time," or they could be in for a shock when bad times inevitably return.

Is Ares Capital a buy now?

When it comes to determining if Ares Capital is a buy now, the answer, like with so many other investments, is that it depends. Ares Capital is a high-risk, high-yield stock, which is really a factor of its basic business model. Loaning money to smaller companies, even if the BDC diversifies its investments, comes with sizable risks. When times are good, those risks look small, but when times are bad, many portfolio investments could falter all at once. While Ares Capital is well-run and has the backing of well-respected Ares Management, the stock is probably only appropriate for risk-tolerant investors.

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Reuben Gregg Brewer 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.