10%-Yielding Ares Capital: When Bad News Is Good News (NASDAQ:ARCC)

Market volatility seems like an understatement these days, especially considering the 800 point swing in the Dow Jones Industrial Average on November 2nd, when the market first reacted on optimism only to be disappointed later when Fed Chairman Jerome Powell indicated that “we have a ways to go” on interest rate hikes. After all is said and done, this has created a number of bargains in the market.

While some names deserve to be cheap, it’s important to separate the wheat from the chaff. This brings me to Ares Capital (NASDAQ:ARCC), which is well-positioned to benefit from higher interest rates. This article highlights why ARCC is an attractive high yielding buy at present, so let’s get started.

Why ARCC?

Ares Capital is the largest BDC by asset size, and is externally managed by the well-respected Ares Management (ARES), a leading alternative asset manager that operates in the credit, real estate, and private equity spaces. It was founded 18 years ago, and at present, carries a $21.3 billion investment portfolio at fair value that’s spread across 458 different portfolio companies.

ARCC was one of the few BDCs to grow its portfolio during the pandemic in 2020, and has grown its portfolio every quarter over the past 12 months, by 21% from $17.7 billion and 371 investments in the prior year period. The portfolio is majority weighted (68%) towards senior secured loans, and notably, ARCC has 9% of its assets invested in Ivy Hill Asset Management, another asset manager whose president is affiliated with ARCC. The remainder of ARCC’s investments are in higher yielding senior subordinated loans and preferred equity, as well as other equity for potential upside to NAV per share.

Like most BDCs, ARCC’s investment portfolio is primarily weighted towards floating rate debt instruments, which represent 73% of portfolio fair value. Rising interest rates have benefited these investments, as supported by ARCC’s rise in weighted average yield on debt from 8.9% in Q3 of last year to 10.8% at the end of September this year.

Based on the comments from the Fed Chairman on November 2nd, it appears interest rate hikes will continue, and that should only benefit ARCC with higher yields on floating rate debt investments. Risks, of course, include the potential for financial stress that higher interest rates would levy on ARCC’s portfolio companies. Portfolio weighted average interest coverage ratio has trended down from 2.9x in Q1 of this year to 2.0x at present.

While this is worth monitoring, portfolio weighted average EBITDA is trending in the right direction, growing from $157 million in Q3 of last year to $213 million at present. Also encouraging, non-accruals remain low, sitting at just 0.9% of portfolio fair value.

Meanwhile, ARCC’s leverage remains safe with a debt to equity ratio of 1.27x, and management expressed their intent to bring it down. They’re also positioning the portfolio towards safer investments, with $1.1 billion of new commitments since the end of Q3, with a 68% weighting towards first lien senior secured loans (compared to 45% portfolio average), 31% towards second lien senior secured loans, and just 1% in new equity investments. Moreover, 98% of commitments since the end of Q3 were floating rate (compared to 73% portfolio average), enabling ARCC to further take advantage of a rising rate environment.

These positive factors likely contributed to ARCC raising its dividend, which now sits 17% higher than where it was last year. The new $0.48 per quarter dividend rate is also well-covered by ARCC’s NII per share of $0.57 in Q3.

Lastly, I find ARCC to be attractively priced at $19.35 with a price to book value of just 1.04x. As shown below, ARCC’s price to book has generally trended in the 1.1 to 1.2x range over the past 3 years. Analysts have a consensus Strong Buy rating on the stock, with an average price target of $21, implying the potential for a double-digit total return including the dividend.

Investor Takeaway

The news from the Federal Reserve of continued rate increases may seem bad on the surface, but it’s actually positive for BDCs like ARCC, which is well-positioned to benefit. Meanwhile, ARCC maintains a diversified portfolio with growing EBITDA and has a low non-accrual rate. ARCC dipped in sympathy with the rest of the market on rate hike news, and is currently appealing with a 10% regular dividend yield that’s well-covered by net investment income.