When surveying the investment universe for options, income investors need to be careful to avoid yield traps. A yield trap is a company that pays a potentially unsustainable dividend.

A yield trap can come about for a few reasons, including a burdensome debt load, a declining business, or an elevated dividend payout ratio. Sporting a whopping 10% dividend yield, investors may initially think that the business development company (BDC) Ares Capital (NASDAQ: ARCC) is a yield trap. But here is why that doesn't appear to be the case.

Over the past three decades, the proportion of loans made to middle-market companies by U.S. banks has dropped precipitously to around 8% today. That is because banks have become more conservative and would rather lend to more mature companies with better credit ratings. For the sake of clarity, companies must typically generate between $10 million and $250 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) annually to fit into the middle-market category.

Continue reading

Source Fool.com