Business Development Companies, or BDCs, could be a good fit for investors looking to generate higher dividend income. BDCs widely offer much higher yields than the average stock. While the average stock in the S&P 500 yields less than 2% right now, many BDCs offer yields of 5%. Some BDCs have even higher yields.

With this in mind, we created a BDC list with a group of high-yield BDCs that could generate strong returns through dividends and a rising share price. Due to its 8%+ yield and strong business model, Ares Capital (ARCC) is our top BDC selection for 2020.

Business Overview

Business Development Companies are closed-end investment firms that make money by investing in debt and equity securities, mostly in small privately-held companies. They allow for investors to participate in venture capital and private equity, which was previously limited to accredited investors.

There are unique risk factors associated with investing in BDCs, such as interest rates and leverage. BDCs utilize debt significantly to make portfolio investments. In a recession, this use of leverage could backfire. Investors should analyze individual company balance sheets within the BDC asset class before investing.

Ares Capital is a Business Development Company that invests in both debt and equity securities, primarily in middle-market companies. It has assets under management of approximately $144 billion. Ares has a market capitalization above $7 billion. Approximately 74% of AUM is invested in credit instruments such as first and second lien senior secured loans and mezzanine debt. Another 17% of investments are placed in private equity, with the remaining ~9% invested in real estate.

Ares performed well over the course of 2019. In the most recent quarter, earnings-per-share increased 6.3% from the same quarter last year. Through the first three quarters, net asset value, or NAV, increased 0.8%. NAV also has risen to $17.26 from $17.12 at the beginning of the year. Net investment income grew considerably during the quarter to $212 million, up from $185 million in the year-ago quarter. Future growth will be generated by continued investments in the portfolio. Ares made over $2.4 billion of additional investments in the third quarter.

Expected Returns

The most attractive aspect of Ares Capital stock, at least for income investors, is its 8.5% dividend yield. Indeed, we believe the dividend will comprise most of the returns generated by the stock over the next several years. We expect NII will grow by approximately 1% per year through 2025, with a modest offset from a declining valuation multiple. Overall, we expect total returns between 9%-10% per year over the next five years.

Importantly, the dividend appears to be secure. Ares Capital has a relatively strong balance sheet for a BDC, with an investment-grade rating from all three major rating agencies. It has a diversified investment portfolio with over 300 different companies and a weighted-average interest coverage above 2x.

Final Thoughts

BDCs have a number of unique risks that investors should carefully consider. But for those investors who are interested in BDCs, Ares Capital is our top pick for 2020. It has a well-diversified investment portfolio and a track record of success. It also has solid debt metrics and credit ratings. With a high yield above 8%, we believe Ares Capital is an attractive BDC for income investors.

Ben Reynolds is CEO of Sure Dividend. Sure Dividend helps individual investors build high quality dividend growth stock portfolios for the long run.