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 examine how Annaly Capital (NYSE: NLY) stacks up. In this series, we consider four critical factors investors should examine in every dividend stock. We'll then tie it all together to look at whether Annaly is a dividend dynamo or a disaster in the making.

1. Yield
First and foremost, dividend investors like a large forward 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 a whopping 13.3%, considerably higher than the S&P 500's 2.1%.

2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company paid out in dividends last year to the earnings it generated. 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, even when its dividend yield doesn't seem particularly high.

As a real estate investment trust (REIT), however, Annaly is required by law to pay out more than 90% of its earnings in the form of dividends in return for not having to pay corporate income taxes.

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 generally a good measure of a company's total debt burden, but remember that for mortgage REITs like Annaly, debt is a big part of their business model. It's also important for mortgage REIT investors to consider portfolio makeup, since leverage isn't the only kind of risk. The proportion of mortgage-backed securities not guaranteed by Fannie and Freddie is a good first glance at portfolio risk.

Let's see how Annaly stacks up next to its competitors:

Source: S&P Capital IQ, company filings.

As far as mortgage REITs go, Annaly uses only moderate leverage to finance a default-safe portfolio. American Capital Agency carries more leverage, but it too has a portfolio guaranteed against defaults. Invesco carries moderately high debt and a bit of portfolio risk, while Chimera carries the most portfolio risk but only modest leverage, relatively speaking.

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.

REITs have been enjoying a boom in recent years, as low interest rates have driven their cost of funding down much faster than the yield on their investments. That equation can't last forever, but it's unclear when it will change. Last month the Fed announced it expects interest rates to remain near zero through 2014. But that good news for REIT investors doesn't preclude long-term rates from falling further should the Fed become more concerned over the pace of economic recovery.

The Foolish bottom line
With a large yield, moderate leverage as far as its industry is concerned, and economic conditions working in its favor for the time being, Annaly looks like a dividend dynamo, though these high dividend payouts are almost certain to come down eventually. If you're looking for some other great dividend stocks, I suggest you check out "Secure Your Future With 11 Rock-Solid Dividend Stocks," a special report from the Motley Fool about some serious dividend dynamos. I invite you to grab a free copy to discover everything you need to know about these 11 generous dividend-payers -- simply click here.