A while back, I wrote that investors should begin preparing their portfolio for a rising interest rate environment.

In that piece, I broadly recommended the financial sector. As the Federal Reserve raises rates, banks will loan out money for higher rates. The interest they pay out (to deposit holders like you and me) will rise, too, but they will lag. This “spread” creates a nice recipe for rising profits.

In that piece, however, I mentioned that not all lenders are created equal. Some will benefit from rising rates more than others. I also mentioned another key beneficiary: business development companies (BDCs). With borrowings typically locked in at fixed rates and loans left to float, these will be a key beneficiary of the changing interest rate winds. Even better, BDCs often pay two to three times the yield of your average bank.

I want to focus a little more on BDCs today, because they are a little-understood asset class.

You typically won’t hear about them on the financial news channels on television. But income-minded investors would be wise to familiarize themselves with these unique investments.

The ABCs Of BDCs

BDCs are familiar ground to my readers over at High-Yield Investing. I’ve covered several over the years, and I even wrote a little bit about them here back in August. But let’s recap some what I said back then. (And in just a second, I’ll tell you about one of my favorites…)

BDCs were created to get capital flowing into smaller to mid-sized privately held businesses. Prior to their establishment in 1980, options for developing and expanding were limited in terms of traditional bank lending. Although, it should be noted that sometimes this cash is used for leveraged buyouts or other big transactions.

This financing can take many forms, from simple unsecured loans to collateralized senior debt to hybrid convertible bonds. It’s not uncommon for some loan packages to have an equity component that gives the BDC an ownership stake in the borrowing company, too.

Similar to REITs, BDCs are exempt from federal income tax as long as they distribute at least 90% of profits to shareholders. That makes them some of the highest-yielding investments around. It’s not uncommon for a BDC to pay a yield of, say, 8% (or even higher).

Music to an income investor’s ears. Of course, I’ve always told readers to be cautious about any security paying such a high dividend. For equities, with a few exceptions, it’s often a sign that there’s trouble brewing underneath the surface. The same goes with BDCs. But thanks to their unique structure, the average yield is higher than your typical stock. (We should still do our own due diligence, of course.)

It’s also worth noting that because these companies don’t retain any profits, they must borrow or issue new shares to raise funding if they want to keep growing. But if you dig into this asset class, you’ll find some established players with a history of surviving uncertain markets.

One Of My Favorites

There are about two dozen choices out there, and they all use different tactics and carry their own unique risks. But the biggest among this group is Ares Capital (Nasdaq: ARCC).

With a market capitalization of about $10 billion and total assets of $21.8 billion, Ares ranks as the nation’s largest business development company. It’s also one of only three in this industry to garner an investment-grade credit rating.

Like other BDCs, Ares provides financing to private companies in need of cash through senior secured loans and other debt packages. Aside from loan originations, Ares also takes equity ownership positions in some businesses, which provides capital appreciation in addition to steady income.

ARCC currently has 466 portfolio holdings spread across two dozen different industries, from oil and gas to healthcare. But the experienced management staff doesn’t lend money to anyone who comes asking – far from it. The diligent research team rejects 95% of the proposals reviewed and only closes on 5% of the available deals presented.

Being selective keeps the company out of trouble. And even then, in the rare event a company defaults on its loan obligations, ARCC ultimately recovered 100% of the capital extended to those borrowers. But it isn’t sacrificing anything in terms of payouts – not with an average yield on its loans of 11%.

Aside from a rigorous screening process, Ares invests mostly in senior, first-lien loans backed by collateral. That puts it near the front of the collection line in the event of default. But it rarely gets that far. Private equity sponsors back 80% of these borrowers and can provide cash lifelines during times of stress.

The end result is that losses have been minuscule, averaging less than 0.1% on first-lien loans over the years – just $1 for every $1,000 invested. That helps explain the 13+years of rising dividends.

_{Source: ARCC Investor Presentation}

ARCC’s most recent quarterly dividend was $0.48 per share. That annualized payout of $1.92 provides a top-tier yield of 10.4% — more than five times the market average. And while many others are scraping together every last dime to meet their dividends, Ares has room to spare – with an average coverage ratio north of 115% for most of the past decade.

Action To Take

There is plenty to like about ARCC, from disciplined lending and strong credit quality to relationships with institutional investors that feed a steady stream of new deals.

But let’s not forget one of the primary motivations for looking at BDCs (and other plays on rising rates). ARCC’s smartly-positioned loan portfolio puts it in an excellent place to benefit from the Fed’s ongoing rate tightening.

With fewer charge-offs and higher realized gains as a percentage of total assets, Ares has outperformed the broader BDC universe, as well as most commercial banks, for more than a decade. I see no reason that trend won’t continue.

P.S. While ARCC is a solid option, there’s another BDC I like that pays monthly…

Most investors looking for income think they have to settle for quarterly dividends. But there are plenty of high-yielding securities out there that pay you monthly — you just have to know where to look.

That’s why I’ve put together an exclusive presentation that reveals 12 of the most generous monthly income plays on the market today. Get the the details here now.