VYM - Ares Capital: The 10% Marvel That Dominates High-Yield Investing

2023-05-16 14:23:20 ET

Summary

• High-yield investments often come with elevated risks and minimal growth, leading to poor long-term returns.
• Business development companies, or BDCs, mortgage REITs, or mREITs, and oil and gas midstream limited partnerships aka MLPs are common sources of high yields but underperform the S&P 500 Index and the Vanguard High-Yield ETF.
• Ares Capital Corporation is considered the gold standard among high-yield BDC investments, with an 11% yield and a history of high shareholder returns.

Introduction

I'm starting this article the same way I start most of my high-yield-focused articles: mentioning that most high-yield investments make me nervous.

Investments with very high yields often come with close to zero growth and elevated risks, which causes them to report terrible long-term returns.

For example, sources of high yields are often business development companies ("BDCs"), mortgage REITs ("mREITs"), and oil and gas midstream limited partnerships ("MLPs"). There are their yields and long-term total returns (including reinvested dividends):

• VanEck BDC Income ETF ( BIZD ): 11.5% yield.
• iShares Mortgage Real Estate Capped ETF ( REM ): 11.4% yield.
• Alerian MLP ETF ( AMLP ): 7.6% yield.

All these ETFs underperformed the S&P 500 Index (SP500) and the Vanguard High Dividend Yield Index Fund ETF Shares ( VYM ) by a wide margin, as shown below. Again, please note that this is based on reinvested dividends. The mREITs returned less than 1% over the past ten years.

This is what the performance looks like without reinvested dividends:

In this article, I will focus on the Ares Capital ( ARCC ) - a 10%-yielding business development giant with a fat yield and a history of high shareholder returns.

While it may sound like I'm overselling, I believe that ARCC is the gold standard among high-yield BDC investments.

I will explain why ARCC is the go-to place for investors seeking ways to beef up their average portfolio yields.

So, let's get to it!

Alternative Income With BDCs

Business development companies are closed-end investment companies that serve the purpose of investing in small and emerging businesses, as well as financially distressed enterprises.

By investing in BDCs, individuals gain exposure to a diverse range of assets within private companies' capital structure, including senior secured and subordinated debt and preferred and common equity.

BDCs face certain investment restrictions and primarily allocate their funds to eligible portfolio companies. Typically, these companies include small businesses in the early stages of development or financially troubled enterprises lacking access to conventional financing options. With traditional lenders, such as banks, burdened by increased regulatory requirements, they struggle to provide loans to small and mid-sized businesses.

Hence, there is a growing demand for BDC capital. These companies have emerged as vital sources of funding for American businesses that would otherwise face difficulties in obtaining financial support.

While BDCs have the flexibility to invest in both debt and equity, their primary focus is providing floating-rate loans to their client companies. These loans offer attractive interest rates relative to fixed-income instruments issued by larger and more creditworthy companies, varying based on the size and creditworthiness of the borrower.

Investing in BDCs can bring several potential benefits, including;

• a certain level of protection in the event of rising interest rates;
• the potential for high income;
• and the possibility of capital appreciation - albeit often limited.

As a result, BDCs have become an appealing option for investors seeking yield.

What Makes Ares Capital So Special

Like all BDCs, ARCC is regulated under the Investment Company Act of 1940.

The company's investment objective is to generate current income and capital appreciation through debt and equity investments, primarily focusing on U.S. middle-market companies.

Ares invests in various types of loans, including senior secured loans (like first-lien and second-lien loans), subordinated debt, and preferred equity. The company may also make non-control equity investments.

Furthermore, Ares Capital Corp believes that its investment adviser, Ares Capital Management, can leverage its resources and relationships to provide attractive investment opportunities. Ares Capital Management is a subsidiary of Ares Management Corporation ( ARES ), a global alternative investment manager with a market cap of roughly $25 billion.

ARCC benefits from its affiliation with the Ares platform, which operates integrated groups across various investment sectors. This affiliation provides a competitive advantage through Ares' deal flow generation, due diligence, and marketing activities. In other words: size and expertise benefits that smaller BDCs cannot compete with.

With that being said, Ares has a strong focus on middle-market companies and benefits from its extensive network of relationships within this sector. Ares' investment philosophy emphasizes capital preservation, low volatility, and downside risk minimization. ARCC concentrates its investments in industries with predictable cash flows and leverages Ares' industry expertise and relationships to make informed investment decisions.

Its investments in corporate borrowers typically range from $30 million to $500 million, but the actual sizes may vary based on factors like capital availability and economic conditions. Common equity investments are usually non-control equity investments of less than $20 million, often combined with a concurrent debt investment. ACC may adjust the size or nature of these investments over time.

While ARCC's main focus is generating income and capital appreciation through debt and equity investments in eligible portfolio companies, they are allowed to invest up to 30% of their portfolio in non-qualifying assets.

Thanks to these qualities, ARCC has outperformed the VanEck BDC ETF by a mile since its inception roughly ten years ago. Please note that ARCC has a 20% weighting in that ETF, making it the biggest holding.

It's also noteworthy that the company's stock has remained strong going back to 2004. While the Great Financial Crisis, the 2015 manufacturing recession, and the pandemic have all caused high short-term capital losses, the stock always quickly recovered, protecting income-oriented investors against capital losses.

Now, let's look at the ARCC dividend and recent developments, especially in light of macro challenges and elevated interest rates.

The ARCC Dividend & Recent Developments

In Q1 2023, ARCC's core earnings per share increased by 36% year-over-year, driven primarily by higher interest rates on new investments.

While the company's numbers missed estimates (we can ignore that), both core and GAAP earnings exceeded the regular quarterly dividend of $0.48 per share, resulting in modest growth in NAV per share to $18.45.

This dividend translates to a 10.4% yield.

Related to this, as of year-end 2022, ARCC estimated its undistributed taxable income (or spillover) to be $650 million, which is $1.19 per share. This level of spillover income is almost 2.5x its regular quarterly dividend.

We continue to believe that having a healthy level of spillover income is beneficial to the long-term stability of our dividend. We will continue to monitor our undistributed earnings and balance these levels against prudent capital management considerations. - Penelope Roll , ARCC CFO.

The weighted average yield on ARCC's debt and other income-producing securities at amortized cost was 12% as of March 31, 2023. This is an increase from 11.6% on December 31, 2022, and 8.9% on March 31, 2022. Furthermore, the weighted average yield on total investments at amortized cost was 10.8%, which also demonstrated growth from the previous periods. These increases in yields can be attributed to the ongoing rise in interest rates, positively impacting ARCC's investment returns. This shows that BDCs are often great tools in rising-rate environments, as discussed in the first part of this article.

Despite the relatively slow transaction environment and market volatility due to economic uncertainty and turmoil in the banking system, Ares Capital believes that the constrained activity of banks makes their flexible capital solutions more valuable.

Hence, the company sees the current environment as an opportunity for direct lenders, as evidenced by private capital providers completing 95% of first-quarter LBO financing new issuance.

To benefit from these opportunities, the company has made significant investments in its direct lending platform, building a team of 170 professionals with deep industry expertise across various sectors. They have transacted with over 440 sponsors and financed approximately 250 non-sponsored borrowers. In Q1, Ares Capital evaluated a larger number of deals, representing a broad set of industries.

Nonetheless, for the sake of risk management, the company's selectivity rate remains consistently low, allowing them to make the best relative value decisions while committing capital. Their investment strategy focuses on high free cash flow and recession-resilient businesses, which contributes to strong overall credit performance. Everything else would be just adding unnecessary risks instead of capitalizing on the current macro environment.

Not only that, but prudent business decisions in the past have resulted in a portfolio of strong business companies. Ares Capital's borrowers have shown healthy growth and profitability, with a year-over-year weighted average EBITDA growth rate of 8%, consistent with the past decade's experience.

It also helps that leverage and interest coverage remain unharmed by economic headwinds. Although it doesn't help that interest coverage has come down from 2.9x in 1Q22. While the company's portfolio is still healthy, we're dealing with a company that will likely see more downside if current macroeconomic conditions do not improve.

According to Ares, the portfolio is well-positioned to withstand inflationary pressures, with the percentage of investments highly impacted by inflation remaining consistent and at managed levels.

The weighted average loan-to-value in the portfolio, including junior loan investments, stands at 43%, providing strong downside protection.

However, Ares Capital expects that a slowing economy may introduce more stress into the portfolio and the broader credit markets.

The company itself is also healthy.

The debt-to-equity ratio net of available cash decreased from 1.26x in 4Q22 to 1.09x in 1Q23, primarily due to net repayments and sales from its portfolio.

Additionally, the company raised roughly $477 million in equity, further contributing to the strengthened capital structure. ARCC's liquidity remained robust, with total available liquidity amounting to approximately $4.9 billion, inclusive of available cash and post-quarter-end debt capital activities.

Valuation

ARCC's valuation is fair. The stock trades slightly below its book value. Its yield is 10.5%, which is one of the highest in the past decade.

Although there are high chances of another dip if the Fed is forced to maintain elevated risks for longer than the market expects, I believe that current prices offer opportunities for income-focused investors.

Furthermore, while I believe that ARCC is the gold standard of high-yield investing, I do not suggest that investors go overweight in ARCC. I prefer diversified ETFs with lower yields, like VYM or the Schwab U.S. Dividend Equity ETF™ ( SCHD ), over high-yield investments.

Nonetheless, ARCC is a great tool to enhance one's high-yield portfolio. The risk/reward of ARCC in the >10% space is almost unbeatable.

Takeaway

Ares Capital stands out as the gold standard among high-yield business development companies. Unlike many high-yield investments that come with minimal growth and elevated risks, ARCC has a history of delivering high shareholder returns.

ARCC benefits from its affiliation with Ares Management Corporation, a leading global alternative investment manager. This affiliation provides a competitive advantage through a strong deal flow, due diligence capabilities, and extensive industry expertise.

The company's investment philosophy emphasizes capital preservation, low volatility, and downside risk minimization.

ARCC has consistently outperformed its peers and maintained a strong stock performance, with its dividend remaining stable even during challenging market conditions. The company's core earnings have been increasing, driven by higher interest rates on new investments.

With a dividend yield of 10.4% and a solid track record, ARCC offers investors a reliable income stream. The company's prudent business decisions have resulted in a portfolio of strong and resilient businesses, contributing to overall credit performance.

While Ares Capital presents opportunities for income-focused investors, it is advisable to maintain a diversified portfolio and not be overweight in high-yield investments.

The bottom line is that Ares Capital can serve as a valuable tool to enhance one's high-yield portfolio due to its favorable risk/reward profile in the >10% yield space.

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