This is an extract from an earlier article at Systematic Income Premium.
In this article, we catch up on Q3 results from the Business Development Company Ares Capital (ARCC). ARCC is currently trading at a total dividend yield of 10.5% and a valuation of 104%.
Overall, ARCC investors, and BDC investors more broadly, should be heartened by the Q3 performance. Net income rose sharply, NAV fell only marginally and portfolio credit quality was broadly unchanged. This result mostly echoes our expectations that we have discussed in our BDC Weeklies over the last few weeks and why we thought BDCs could easily get a pop from their depressed valuation levels. Time will tell if the rest of the sector follows up with similarly strong results but the ARCC Q3 numbers are a great start to the earnings season.
Quarter Update
ARCC NAV fell 1.3% over the quarter – slightly more than in Q2, primarily due to unrealized losses from wider credit spreads.
Core income (red bars) rose by 9% to $0.50 – the second quarterly gain.
Total investment income came in at the highest level over the last couple of years despite a subdued level of prepayment fees – a feature of a weak credit market. Interest income continues to benefit from rising short-term rates after a brief dip in Q1 due to the presence of Libor floors.
Income Dynamics
In this section we highlight some of the key factors that will drive net income over the medium term.
The weighted-average yield on income-producing securities at fair-value jumped to 10.7%, primarily as a result of the rise in short-term rates. As the chart shows, some of that will be eaten away by rising debt costs (red bars) as well as potentially higher non-accruals and realized losses. The second reason for the rise in asset-side yield is the rise in credit spreads. Management have indicated that spreads are around 1% higher than the 5-year average for similarly-leveraged loans. This is due to the widening in credit spreads in publicly traded loans as well as the fact that banks, which ARCC competes with for new lending, are stepping back from new origination due to their backlog of previous issuance.
The company has a lower level of floating-rate debt in the sector but also a lower level of floating-rate debt. Over Q3 the percentage of floating-rate assets decreased marginally as did the percentage of floating-rate debt.
Libor has continued to rise sharply over the last quarter. It finished Q3 at 3.75% – a rise of 1.45% over the quarter. Moreover, since the end of the quarter it has risen to 4.36% as of this writing or another 0.61%. In short, rising short-term rates will continue to deliver net income gains over the following several quarters at least.
Portfolio Quality
Portfolio quality is holding up very well. Non-accruals were flat over the quarter. Two companies were added to non-accrual and three were removed.
Internal portfolio quality grade was fairly flat as well.
Takeaway
ARCC delivered a 1.1% total NAV return over the quarter – a great result for investors and indicative of strong returns for the broader sector. Rising short-term rates, combined with stable portfolio quality, should continue to deliver growth in net income along with dividend hikes. A large spillover should also lead to further special dividends.
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