Before you get sucked in by Annaly Capital’s huge 13%-plus dividend yield, you’ll want to take a look at the risk of a dividend cut.
If there’s one thing most dividend investors try to avoid at all costs, it is a dividend trap (a high-yield stock that is about to cut its dividend).
Annaly Capital Management (NLY 1.34%), with its ultra-high 13% dividend yield, is flashing some important warning signs that it’s about to spring its trap.
Here’s what you need to know before you buy Annaly Capital Management stock thinking you’ve found a reliable dividend stock for your portfolio.
What does Annaly Capital Management do?
On the surface, Annaly Capital, a real estate investment trust (REIT), might seem like a dividend investor’s dream. The REIT sector is normally filled with boring dividend stocks that are built from the ground up to provide a reliable income stream to shareholders. But most REITs own physical properties that they lease out to tenants, producing steady cash flows over time. Annaly isn’t run like that; it is a mortgage REIT.
Image source: Getty Images.
Mortgage REITs buy mortgages that have been pooled into bond-like securities. These securities trade all day and the value of Annaly’s portfolio will fluctuate accordingly. It earns interest from the bonds, but they are impacted more directly and quickly by things like interest rate changes, housing market dynamics, mortgage demand, repayment trends, and delinquency rates. The mortgage REIT model is way more complex than the businesses of most property-owning REITs. Before buying any mortgage REIT investors should do a deep dive to understand what these types of REITs really do.
That’s the first big risk that has to be considered by potential investors. The second one is that mortgage REITs often use leverage in an attempt to enhance returns. That leverage is usually backed by the value of the mortgage bond portfolios they own, which can change dramatically when there are market dislocations. If the value of these securities drops, mortgage REITs can be forced to sell assets, sometimes because of margin calls, at the worst possible times. While leverage can enhance returns, it can also exacerbate losses.
What does Annaly’s dividend history look like?
Let’s assume you believe that you can handle a complex investment that makes use of leverage. All good. But if you are a dividend investor, could you handle years of dividend cuts and a declining stock price? Look at the graph below for Annaly and consider how an income investor would have fared.
NLY data by YCharts
The purple and orange lines are the first ones to consider. They show that the dividend and the stock price have headed steadily lower over the past decade, meaning that shareholders would have been left with capital losses and less income if they were using the dividend income to pay for living expenses. But notice the blue line, which is dividend yield. Because of the basic math of dividend yield, it has remained high the whole time despite the terrible outcome for the dividend and stock price.
But that’s the past — what about the future? Well, things aren’t exactly rosy today. For example, Annaly’s book value (basically the value of its mortgage bond portfolio) rose between the fourth quarter of 2023 and the first quarter of 2024, but it fell year over year, going from $20.77 per share in the first quarter of 2023 to $19.73 at the end of March in 2024. That’s a 5% change in the wrong direction.
A smaller portfolio can make it harder to produce income since there are fewer assets on which to earn interest. Notably, at the end of 2013, the book value was listed as $12.13, but you have to take into account the 4-for-1 reverse stock split in 2022. When you do that, the 2013 book value becomes $48.52. In other words, the portfolio is less than half the size it was roughly 10 years ago.
And then there’s the $0.65-per-share dividend the REIT paid in the first quarter. That was a penny higher than the $0.64 per share it generated in earnings available for distribution, down from a far more robust $0.81 a year earlier. In other words, it paid out more than it earned in the first quarter of 2024. That’s not terrible, but it isn’t a good trend and it is one that can only be supported for a short period of time before something has to give (often the dividend). Given the history here on the dividend front, conservative investors should probably focus on lower-yielding REITs with more reliable dividend histories.
Maybe Annaly cuts, maybe it doesn’t
The truth is that Annaly’s dividend could go either way. The board could continue to support it or it could cut it, but for investors trying to live off of the income their portfolios produce this REIT is not a great risk/reward trade-off. And the risks right now appear to be increasing, not receding.