Ares Capital: “Misunderstood” Buy

10/28/2014 8:00 am EST

Focus: STOCKS

Adrian Day

Chairman and CEO, Adrian Day Asset Management

It's time to step up and do some buying; one new recommendation is a Business Development Company (BDC)—in a high-yielding sector we have long liked—explains Adrian Day, editor of The Global Analyst.

Ares Capital (ARCC) is the largest of the dividend-paying BDCs and one of the better run and more conservative.

BDCs had been weak this year, even before the broad market selloff. In the late spring, S&P (SPX) and then Russell booted the sector out of the stock indices, which promoted selling by passive index investors.

Then came fears of rising interest rates, which is largely misplaced. Since over 80% of its loans are floating, it will receive more income as rates rise.

Moreover, a period of rising rates typically sees wider spreads, overcoming the yield compression that has hurt returns in the sector over the past year, thus offsetting the lower yields from senior debt.

In recent quarters, Ares has been moving more towards senior lending, which carries lower yields; some 44% of its loans are now senior, secured debt, which have a reduced risk of default.

Already, Ares sports a low non-performing ratio of 1.2% of assets-Ares has carry forward income of about 82 cents per share as of the end of the year-which is very significant on a regular dividend payment of $1.52.

This undistributed income enabled Ares to pay two special dividends over the past 12 months and we expect another one later this year.

Ares has a strong balance sheet, with a reasonable debt-to-equity ratio of 0.6 times; it has also extended its debt maturities, with no debt at all due until 2016.

Ares sports a very attractive yield of 9.94%; this yield excludes special dividends and is well covered by very stable income. The stock also trades at a rare discount to book.

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