Is Ares Capital Stock a Buy Now?

Key Points

• Ares Capital provides loans to smaller businesses.

• The company's loan portfolio throws off material amounts of cash, which gets passed on as dividends to shareholders.

• Ares Capital's 8%-plus yield is attractive, but investors need to understand the inherent risks of the business model.

• 10 stocks we like better than Ares Capital ›

If you are looking at Ares Capital (NASDAQ: ARCC) it is most likely because of the stock's hefty 8%-plus dividend yield. For reference, the S&P 500 index (SNPINDEX: ^GSPC) is only offering a yield of 1.2% today. And the average financial stock has a yield just shy of 1.4%. It makes complete sense that income seekers would find Ares Capital's yield appealing. But does that make it worth buying now?

What does Ares Capital do?

Ares Capital is what is known as a business development company (BDC). This is a unique corporate structure that is designed to provide financing to smaller companies. Essentially, Ares provides loans to businesses that might otherwise find it hard to access affordable growth capital. It is supposed to provide some guidance along with the loans, but the big story for investors is the interest that it earns on the loans it makes.

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This is where things get interesting. The average interest rate that Ares Capital's loans carried in the first quarter was 11%. That's a pretty high interest rate, but still, the companies it works with are happy to pay it. This is because the companies are so small or their finances are so weak that other options would be even more costly. That's not a knock on the companies with which Ares is partnered, per se; it is merely a statement of fact.

Banks tend to avoid higher-risk companies. Tapping the capital markets for cash comes with material upfront costs, there's no guarantee of success, and then you have to appease a pool of investors, not just a single investor like Ares. All in, Ares Capital is providing companies with an important service and making a good return for doing so.

There's a risk problem with the BDC model

The truth is, Ares Capital has a strong history and appears to be a fairly well-run BDC. If you want to own a business development company, it should be on your short list. But don't overlook the inherent risks of the BDC model.

For starters, the high yields on the loans Ares makes are a material financial burden for a company. If a business is growing strongly in a good economy, that's probably not a big deal. But what happens when the economy falls into recession? During the Great Recession, between 2007 and 2009, several large BDCs ended up going out of business or getting bought out after the loans they made started to see repayment headwinds. The economy has had a good run of late, but it won't last forever.

Then there's the nature of the loans. Roughly 70% of the loans Ares Capital has made are floating rate in nature, which means that the interest rate goes up and down along with interest rates as set by the Federal Reserve. That sounds good on the surface, but if rates rise, the cost of the debt goes up for the companies Ares has given loans to. Rates tend to rise when the economy is doing well, as the Fed tries to cool off economic excesses. So even good times can be a problem here.

Data by YCharts.

This is not a knock on Ares Capital, which has done a good job of navigating the inherent complexity of its business. But its dividend has been variable, and its stock price tends to take a big hit during economic downturns. Yes, there's a lofty yield on offer here, but it comes with risks that more conservative income investors probably won't want to accept.

Know what you're buying before you buy it

Whether or not Ares Capital and its huge 8%-plus dividend yield is worth buying now really depends on your investment style. How will you handle adversity when, not if, it comes? If the answer is you are comfortable holding through a deep stock decline, a dividend cut, or even both at the same time, Ares Capital could be a good option for you. If what you really want is a reliable dividend that grows steadily over time, well, Ares will probably be a bad choice for your portfolio.

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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.