How Low Could Annaly's Dividend Go?

With other sources of investment income drying up fast, more investors are relying on dividend stocks to provide them with the cash they need. But relying on dividends can be dangerous, especially when companies have a history of both increasing and decreasing their payouts over the years.

Today, I want to look at Annaly Capital (NYSE: NLY  ) . The mortgage REIT is well-known for its extremely lucrative dividend yield, but what many investors may not realize is that the company's payouts haven't always been nearly as generous as they are today. With Annaly already having cut its dividend by a third since the end of 2009, how much further could shareholders see their dividend payments drop in the future?

Showing you the money
Mortgage REIT investors have gotten spoiled by the extremely favorable conditions that have prevailed for several years. With the Federal Reserve keeping short-term interest rates extremely low, it's been a lot easier for mortgage REITs to produce the huge yields they're famous for. That's led to a big expansion in the industry, with American Capital Agency (Nasdaq: AGNC  ) , Invesco Mortgage Capital (NYSE: IVR  ) , and Chimera Investment (NYSE: CIM  ) all quickly ramping up the size of their balance sheets.

But it wasn't always like this. Go back to 2005 and 2006, and you'll get a much different picture of what the industry looked like. Starting in 2004, the Federal Reserve slowly but surely clamped down on monetary policy by making 17 consecutive quarterly rate increases, taking the Fed Funds rate up from 1% all the way to 5.25%.

As you'd expect, those rate increases played havoc with Annaly's interest income. In 2004, Annaly managed to keep almost half of the interest it earned on its mortgage-backed securities portfolio after paying its financing costs. It also banked a gain on the sale of some of its assets, adding to its net income and helping to support its dividend yield at the time of more than 10%.

By 2006, however, higher financing costs cut much more deeply into the income that Annaly generated from its investments. During that year, after paying interest on its loans, the mortgage REIT was able to keep only 14% of the income its mortgage portfolio generated. Moreover, rising interest rates led to additional losses when Annaly sold off some of its investments.

Those harsh conditions forced Annaly to cut its dividend by 80% within a year and a half. Although subsequent dividend payments were somewhat higher than the December 2005 dividend, which marked the low point for that interest rate cycle, Annaly's dividend yield for the entire year of 2006 was just 4% -- even as the stock traded 30% to 50% below its early 2005 levels.

Will it happen again?
Interestingly, we're already seeing a substantial reduction in Annaly's interest margins. In 2010, Annaly kept $0.45 of every dollar in interest its portfolio earned, after accounting for interest expenses. But over the past 12 months, that figure has plunged to less than 9% -- well below the low levels it hit in 2006.

That's a bit alarming, given that the Fed hasn't yet moved to raise short-term rates. But with the Fed's buying of longer-term bonds, including the same mortgage-backed securities that Annaly invests in, the interest squeeze this time around is coming both from the interest-income side of the income statement as well as the interest-expense side.

So far, Annaly has been able to keep posting gains on sales of mortgage assets, boosting its bottom line. When rates eventually rise, that last tailwind could disappear. At that point, the same size of dividend cuts we saw in 2005 and 2006, when dividends fell from $0.50 per share quarterly to $0.10, wouldn't be out of the question if the Fed moves as aggressively as it did in the past.

Go beyond dividends
Obviously, to get a firmer idea of where Annaly's dividend will go, you have to understand its business inside and out. Only by looking closely at the factors that drive Annaly's cash flow and profits can you get a realistic bead on how much further it could cut its payout in the years to come.

Which of those factors is most likely to drive Annaly's dividend going forward? That's one question you'll find answered in the Fool's premium report on Annaly, where our top analysts give you their take on the direction that Annaly's business is moving. Click here today and lock in a year's worth of free updates as well.

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. You can follow him on Twitter, @DanCaplinger. The Motley Fool owns shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.


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  • Report this Comment On October 06, 2012, at 6:21 PM, jonkai wrote:

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    By 2006, however, higher financing costs cut much more deeply into the income that Annaly generated from its investments

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    this isn't the whole story, Mike Farrell (CEO) also told us that a "slow motion car wreck" was coming, every quarter until it came.. and they were pulling in their horns, there was nothing to invest in that was safe, so the CEO did the right thing.

    that slow motion car wreck turn out to be the nearly 2nd greatest depression....

    and when it came NLY took full advantage of the situation and made more money than it ever had before during the four years of the crisis... by leaps and bounds... absurd amounts of money, the kind you are telling us it pulled back from....

    one shouldn't just look at the dividend, one should look at the management of a company.

    what is coming now is wholly different than what produced the housing and credit crisis, where there was an inverse yield curve just before the crisis, the kind that bankrupt many a company, while NLY held its own.....

    now it is impossible for the yield curve to reverse until at least 2015, and in reality longer than that.

    and as long as there is a yield curve this management is able to produce outsized yields from it.

    that is what you missed in the article...

  • Report this Comment On October 06, 2012, at 6:35 PM, jonkai wrote:

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    as well as the interest-expense side.

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    this is just plain wrong, they have never had a low of an expense as they are having now from interest expenses.... and that number is stable until atleast 2015....

    so the pressure is coming from income, the MBS's are showing less rates..

    but you can count on one thing, no body is going to lend one money on a house, unless they can make money doing it.... (and far better than other methods to make it worthwhile)

    this is the number you should have concentrated on. This would have been interesting to figure out... or atleast make an educated guess on...

    because then you could discern how much NLY could make on that, just using that price relative to other prices in the past, and knowing NLY's big expense in swaps is coming down quickly too because of those prices...

    NLY could literally have doubled earnings if they wished by raising leverage a certain amount, and cutting back on swaps... the reason they didn't is to save up that potential for that rainy time you (and everyone else's and their mother) are predicting... what does that mean? it means NLY could produce the same earnings as it did this quarter with a far smaller spread.

    so that bloggers in the future can scratch their heads about how that NLY is still paying outsized yields....

    your job, should you choose to accept, is to find out what that point is that Banks will no longer lend money out for.... and there by deduce the final yield curve....

    no easy task.

  • Report this Comment On October 06, 2012, at 7:02 PM, TMFGalagan wrote:

    @jonkai - On interest expense, take a look at the second-quarter report. Total interest expense rose from $113.3 million in 2011Q2 to $166.4 million in 2012Q2, while interest income fell from $957.1 million to $886.3 million. That's what I meant by getting squeezed on both sides.

    Admittedly, those line items don't include the impact of swaps. But even if you widen the scope to include them, interest income has fallen and interest expense risen both year-over-year comparing 2011Q2 to 2012Q2 as well as sequentially on a trailing 12-month basis.

    best,

    dan (TMF Galagan)

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