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Better Buy: Ares Capital or FS KKR Capital?

When it comes to income-paying stocks, business development corporations (BDCs) tend to have some of the highest dividend yields available to investors. These companies lend to segments of the market that banks tend to avoid and can be a solid source of passive income for investors.

Ares Capital (NASDAQ: ARCC) is one of the largest BDCs in the U.S., paying out a dividend yielding 9.8%. However, it's only one of several BDCs for investors to buy. FS KKR Capital (NYSE: FSK) is another BDC with an even higher dividend yield of 14.1%. Here's what you should know about the two companies and which is a better buy today.

The two BDCs invest in businesses that banks have turned their backs on

Ares Capital and FS KKR Capital are specialty finance companies that provide funding through debt and equity investments in middle-market companies in the U.S. These companies have earnings before interest, taxes, depreciation, and amortization (EBITDA) between $10 million and $250 million, and tend to be overlooked by banks because of the higher perceived risk.

BDCs cater to middle-market companies because banks neglect them in favor of larger enterprises with stronger credit profiles. The trend is evident over the past few decades, as U.S. banks' share of the market for senior secured loans, like those Ares and FS KKR make, has fallen from 33% in 1995 to just 8% in 2021, according to S&P Global Capital IQ.

Ares and FS KKR fill this funding gap, and as BDCs, they are regulated investment companies for tax purposes, meaning they must distribute 90% of their taxable income to shareholders. For this reason, BDCs can be an excellent source of high dividend yields.

One BDC has a longer history to fall back on

The first big difference between Ares Capital and FS KKR is their longevity. Ares Capital went public in 2004 and has a longer track record of success, showing an ability to navigate the challenges during the Great Recession of 2008-2009. FS KKR, on the other hand, went public in 2014 and doesn't have as much historical performance that investors can fall back on.

There is also a slight difference in the composition of the two companies' portfolios. Ares Capital's most significant investments are in software and services (22%), diversified financials (13.3%), and healthcare services (10.8%). Meanwhile, FS KKR's largest investments are in software and services (16.8%), capital goods (15.4%), and healthcare services (12.8%).

Breaking down the two BDCs' debt investments

Another component you can look at when analyzing the two stocks is the type of loans they make. Senior secured debt is the highest-ranking component of a company's capital structure and is the money most likely to be repaid if a company goes out of business or files for bankruptcy. BDCs prefer this debt because it has lower risk and gets a higher priority for repayment than other debt types. First lien loans have the first claim on collateral in the event of bankruptcy, followed by second lien loans, other senior debt, subordinated debt, and finally equity.

Ares Capital has $9.5 billion invested in first lien senior secured loans, which comprise about 43% of its $21.9 billion portfolio. Second lien loans make up another 17% of its investments, with the remaining in subordinated loans and equity investments. Meanwhile, FS KKR has $8.7 billion, or 60% of its $14.7 billion portfolio, invested in first lien loans and another 3% in second lien loans.

One stock trades at a steep discount

Another way you can compare the two BDCs is by looking at their share price divided by their net asset value (NAV). NAV helps investors assess a BDC's fair value and represents the value of the assets that a BDC owns.

In its most recent third-quarter filing, Ares Capital's NAV per share was $18.99, and its price-to-NAV ratio was 1.03. FS KKR's NAV per share is $24.89, and its price-to-NAV ratio is 0.8, which is a significant discount to Ares.

FS KKR trades at a discount because of older assets it had on its books, which it acquired by merging six BDCs together since 2018. Management continues to rotate out these legacy investments from its portfolio, with 90% now originated by KKR credit or the FS KKR advisor, which should improve its asset quality over time.

The final verdict

It's a close call between the two BDCs. Ares Capital has a more extended history of stellar performance since going public in 2004, with a proven record of credit that performs amid challenging economic conditions.

However, FS KKR has more first lien loans and trades at a significant discount to its NAV, providing some margin of safety to investors. The company is improving its investment portfolio, replacing its lower-quality legacy loans with higher-quality KKR-approved originations, which is why I would give a slight edge to FS KKR over Ares Capital at today's current prices.

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Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends S&P Global. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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