Annaly Capital: Dividend Dynamo or the Next Blowup?

Dividend investing is a tried-and-true strategy for generating strong, steady returns in economies both good and bad. But as Corporate America's slew of dividend cuts and suspensions over the past few years has demonstrated, it's not enough simply to buy a high yield. You also need to make sure those payouts are sustainable.

Let's take a look at how Annaly Capital (NYSE: NLY) stacks up in four critical areas to see if it's a dividend dynamo or a blowup in the making.

1. Yield
First and foremost, dividend investors like a large yield. But if a yield gets too high, it may reflect investors' doubts about the payout's sustainability. If investors had confidence in the stock, they'd be buying it, driving up the share price and shrinking the yield.

Annaly yields 15.4% versus, which is dangerously high in absolute terms, but not for its industry.

2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company pays out in dividends to the amount it generates. A ratio that's too high -- say, greater than 80% of earnings -- indicates that the company may be stretching to make payouts it can't afford.

However, the payout ratio is an inappropriate metric for Real Estate Investment Trusts (REITs) like Annaly, as they are required to pay out more than 90% of their earnings in exchange for favorable tax treatment. For REITs, dividends will follow earnings. In Annaly's case, that has meant up, as the spread between short (red) and long term (blue) rates has widened. The area between those two lines represents Annaly's profit spread:

This trend should continue through the short-to-medium term unless the Fed raises short-term interest rates, investors don't go too crazy buying long-term bonds, and the government continues to support the housing market with some kind of guarantee for qualifying loans.

3. Balance sheet
The best dividend payers have the financial fortitude to fund growth and respond to whatever the economy and competitors throw at them. The debt-to-equity ratio is a good measure of a company's total debt burden and a rough measure of how much leverage a financial institution is taking on.

With a debt-to-equity ratio of 600%, Annaly is far more leveraged than a company like Chimera that invests in riskier securities, but it's much leveraged than traditional banks that rely on deposit funding.

Let's examine how Annaly stacks up to its peers:

Source: Capital IQ, a division of Standard & Poor's.

While Annaly's leverage would seem a bit worrisome in absolute terms, when we look at it in the context of its peers, things don't look so bad – assuming you believe in the business model, specifically, you believe that interest rates aren't about to rise or that Annaly has properly hedged itself.

4. Growth
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.

Annaly has grown its earnings-per-share at a 1% rate, while its dividend has grown at an average 9% rate over the past five years -- both medians for the group listed above. Net income and dividend payouts certainly grew much faster, but the share count also grew -- particularly in 2007 and 2008 -- as the company raised capital to expand business.

The Foolish bottom line
Ultimately, the fate of Annaly's dividend is going to come down to the stability of its business model, interest rates, and its ability to successfully navigate and hedge against these factors.

To read more about how these issues affect Annaly, check out "Today's Buy Opportunity: Annaly Capital."