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When it comes to building a great retirement portfolio the most important ingredient is often top dividend paying stocks.
A dividend payment of a few percent every year may not seem like a lot, but when reinvested back into the same stock it can compound into incredible profits over many years or decades. In addition, a dividend acts as a big waving flag to investors that a company's business model is sound and likely to stand the test of time. Finally, a dividend is a great hedge when the market is extra volatile or heading lower that can help investors protect their capital.
On the flip side, when purchasing dividend stocks investors have to be careful not to get caught chasing a high yield. While some high-yield dividend stocks are the real deal, a high-yield could also signify a stock whose business model is struggling (thus a falling share price), or it could represent an unsustainable payout. An unsustainable payout is dangerous because a dividend cut can sometimes cause a company's share price to take a substantial hit.
When it comes to top dividend paying stocks, no sector stands out more than financials which are home to quite a few double-digit yields. Today, we'll take a closer look at the sector's top dividend paying stocks and discover whether they're indeed the real deal, or if they're a high-yield dividend trap.
Western Asset Mortgage Capital (WMC): 18.7% yield
As you'll find with the vast majority of financial high-yield stocks, they tend to be a real estate investment trust in some form or another. In the case of Western Asset Mortgage Capital, we're talking about a company that invests in agency and non-agency mortgage-backed securities. In plainer English, it's able to invest in MBS that are backed against default by the U.S. government (agency) and those which aren't backed by the government (non-agency). Non-agency MBS can yield greater returns in a favorable economic environment, but they also come with greater risks.
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The good news for investors here is that as a REIT Western Asset Mortgage is required to return at least 90% of its profits to investors in order to enjoy a favorable tax status. The problem, though, is with the housing sector somewhat stymied and lending rates projected to begin rising next year, Western Asset's consensus EPS estimates are slightly lower than its current dividend payout. In short, with a dividend payout ratio above 100% it's very likely a dividend reduction is on the way. But, as a consolation to investors, I don't believe the cut will be too substantial and that Western Asset Mortgage's yield will stay well above 10%.
Resource Capital (ACR 1.08%): 15.4% yield
Resource Capital, on the other hand, is a company primarily focused on investing in commercial real estate assets and debt, though it does dabble in residential MBS and debt tranches of collateralized debt or loan obligations as well.
Resource Capital offers a quite healthy yield of 15.4%, but it also comes with a price. Over the past five years as the stock market has rocketed higher Resource Capital's share price is basically unchanged. Furthermore, since 2008 and the credit meltdown Resource Capital's dividend has been more than halved from $0.41 per quarter to just $0.20 per quarter. The reality is that it may be facing its fifth such dividend cut since 2008 in the coming quarters. With a payout ratio of 118% this year and 110% next year the only reasonable means to sustain its payout would be to sell more common stock to substantiate the cash outflow.
Long story short, it's not good news for Resource Capital's shareholders if that happens.
ARMOUR Residential (ARR 3.38%): 15.1% yield
Of the five stocks listed here, this is the one I'd suggest you be the most cautious about. ARMOUR Residential is a mortgage-REIT that benefited from high leverage and the fact that 30-year mortgage rates were traipsing near record-low levels for years. This allowed the purchaser of agency and non-agency products decent lending rate visibility and the opportunity to boost returns via leverage.
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Over the past year, however, ARMOUR has had to take a more conservative investment approach (i.e., more agency loans) since lending rate visibility isn't as certain any more, and its net interest margin has tightened considerably from a few years prior. Also, keep in mind we're talking about a company that was only founded in 2008, so it may still lack the experience to navigate a fluctuating mortgage market. The result has been successively falling EPS estimates, and a monthly dividend payment that's shrunk multiple times from $0.12 per month to just $0.05 per month now. With a dividend payout ratio still in excess of 100% I suspect another dividend cut is on the horizon. Like my fellow Fool Dave Koppenheffer suggests, I'd keep clear of this high-yield stock.
Ellington Financial (EFC 1.74%): 14.1% yield
While ARMOUR might be worth avoiding, Ellington Financial could be the top dividend paying stock of the group.
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Ellington Financial is an investor in agency and non-agency residential MBS, as well as specialty finance situations, such as corporate debt and derivatives, which offer a higher risk-versus-reward profile. Clearly the company is doing something right as its leverage ratio is a very reasonable 1.44-to-1, down from 1.89-to-1 in the second quarter, and 88% of its maturity dates for securitized debt are within the next 90 days. With market volatility having returned, the ability to stay fluid is going to be important for Ellington Financial. It's also worth noting the company is trading below its book value of close to $24.
While I'm not going to rule out the possibility of a dividend cut with its forward payout ratio being just a hair over 100%, I believe any cut here would minimal and that its dividend looks poised to stay healthfully in the double-digit yield territory. At this level an investor could double their principal in seven years or less!
Prospect Capital (PSEC 1.39%): 14% yield
Lastly we have business development company Prospect Capital which, unfortunately, looks like another dangerous rather than beneficial high-yield stock despite the company's recently announced plans to spin off its collateralized loan obligations, real estate investments, and peer-to-peer loans into publicly tradable securities.
Similar to ARMOUR, Prospect Capital has been paying out more in dividends than it's been bringing in for a few quarters now. Currently, it's staring down a payout ratio of 115% of its projected fiscal 2016 earnings.
But, as financial sector-savvy Fool Jordan Wathen opined last week, Prospect Capital's solution to unlock shareholder value – the spin-off – could be nothing more than a rouse to mask a much needed dividend cut. As Jordan points out, Prospect Capital is trading well below its book value and with a purpose; it's carrying a lot of debt and it continues to dilute investors' positions with share offerings. Overall, this looks like high-yield dividend stock best left untouched.
