If you go sifting the market for ultra-high-yield dividend payers, it won't take long before you land on Annaly Capital Management(NYSE: NLY). The stock offers a dividend yield above 14% at recent prices. That's more than 10 times higher than the average dividend payer in the benchmark S&P 500(SNPINDEX: ^GSPC).
Stocks generally don't offer yields at double-digit percentages unless investors are concerned their underlying businesses won't be able to meet their dividend commitment. Annaly Capital recently did the unthinkable. Even though its yield seems unsustainable, the company raised its quarterly payout by 7.7% this March to $0.70 per share.
With its yield so high, it will take a little over five years before Annaly returns your entire principal investment. On the surface, this seems like a no-brainer stock to buy for income seekers, but there are a few things you should know about real estate investment trusts (REITs) that don't own real estate.
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How Annaly Capital makes money
Like every other REIT, Annaly can legally avoid income taxes by distributing at least 90% of its profits to investors as dividend payments. Unlike most REITs, though, it doesn't invest in real estate. Instead, it invests in mortgage-backed securities (MBS) backed by government agencies, mortgage servicing rights (MSR), and residential credit.
March 31, 2023
Agency MBS
MSR
Residential
Credit
Portfolio asset value
$77.6 billion
$1.8 billion
$5.2 billion
Committed capital
$7.7 billion
$1.8 billion
$2.1 billion
Illustrative levered returns
14%-16%
9%-12%
12%-15%
Portfolio asset value
$75 billion
$3.3 billion
$6.6 billion
Committed capital
$8.0 billion
$2.7 billion
$2.4 billion
Illustrative levered returns
16%-19%
12%-14%
13%-16%
Data source: Annaly Capital Management. Table by author.
With increasing returns from all three components of its portfolio, Annaly reported earnings available for distribution that reached $0.72 per share in the first quarter. That's in line with the previous quarter and slightly more than it needs to meet its recently increased commitment of $0.70 per share.
Agency MBSes aren't as large a component of Annaly's portfolio as they seem due to heavy leverage. At the end of March, the company was using about $8 billion in capital to reap returns from an MBS portfolio worth $75 billion.
Annaly's growing mortgage servicing business handles administrative tasks of a mortgage on behalf of the original lender, such as billing and payment collection. Servicers typically receive 0.25% of outstanding loan balances.
Why income-seeking investors should avoid this stock
Diversification toward residential credit and mortgage servicing is a step in the right direction, but investors who need reliable sources of income may want to keep looking.
If you're excited about the high yields mortgage REITs (mREITs) offer, just remember that their loans are secured by their MBS portfolios. The carrying value of MBS or any asset that pays a predetermined yield can shrink significantly when the Federal Reserve raises interest rates.
When interest rates change slowly with lots of foreshadowing by the Federal Reserve, a well-run mortgage REIT like Annaly can trim unattractive assets and acquire new ones fast enough to maintain its dividend payout. A rapid rate increase, such as the one we experienced a few years ago, though, can throw a wrench in the company's gearbox. In a nutshell, rapidly rising rates a few years ago led Annaly to reduce its dividend by 26% in early 2023.
If you look back further, you'll see this mortgage REIT has reduced its dividend payout several times over the past decade. Annaly is by no means an outlier, either. Its peers in the mREIT space, AGNC Investment and MFA Financial, also have significant dividend reductions in their recent history.
At its latest meeting, the Federal Reserve decided to maintain the federal funds rate in a range between 4.25% and 4.5%, but promised to continue reducing its MBS portfolio. While we can reasonably expect Annaly to maintain its recently increased dividend payout for a few more quarters, what happens after that is guesswork. With a future so foggy, passing on this stock is the right move for most income-seeking investors.
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Cory Renauer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
