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.