The big draw for Ares Capital (NASDAQ: ARCC) is its huge 10% dividend yield. Given that the S&P 500 index‘s (SNPINDEX: ^GSPC) yield is a miserly 1%, you can see why dividend investors would find Ares Capital attractive. But investors need to understand what they are buying, or they could end up surprised by a dividend cut. Here’s what a recession and credit downturn could do to Ares Capital’s dividend.
Ares Capital is built to pay dividends
Ares Capital is a business development company (BDC), a corporate structure similar to that of a REIT. Basically, BDCs avoid corporate-level taxation if they distribute at least 90% of taxable earnings to shareholders as dividends. So Ares Capital’s lofty yield isn’t shocking. And unless something goes dreadfully wrong at the company, it will likely always pay an attractive dividend.
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That’s the good news for income investors. But make sure you don’t ignore the bad news.
The problem with BDCs is that they make high-interest loans to smaller companies that lack access to capital markets. The interest rates are shockingly high, with Ares Capital’s customers paying an average rate of 10.3% in the first quarter of 2026. Few companies would pay that high a rate if they had a better option.
Ares Capital, like all BDCs, tries to balance risk and reward. Basically, it invests in businesses it believes can withstand such interest rates. However, many of its loans are floating-rate, so as interest rates rise, so do the interest costs that Ares Capital’s customers have to cover. That can create additional strain and lead to defaults. Ares Capital is used to working with troubled businesses, since there are always some in the portfolio. However, a broader credit downturn could put a significant strain on the BDC’s dividend-paying ability if too many of its customers experience trouble at once.
This has happened before, and it will happen again
Ares Capital cut its dividend in each of the last two recessions. Even beyond that, the dividend has been highly variable. If you are trying to live off your dividends, you probably shouldn’t rely on Ares Capital’s dividend.
That, however, isn’t meant to suggest that Ares Capital is a bad BDC. That’s not the case at all. It is just that the company’s business is inherently risky, and credit downturns and recessions, which happen fairly regularly, can lead to dividend cuts. Added to a diversified portfolio of dividend stocks, Ares Capital could provide extra income to pay for non-necessities, like eating out or a vacation. But if you are counting on Ares Capital’s dividend to pay for living expenses, you may be taking on more risk than you may realize. And you may not find out how much risk you’ve taken on until the dividend gets cut during the next credit downturn.
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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Ares Capital. The Motley Fool has a disclosure policy.
