High dividend yields often come with elevated risks, but that's not always the case. Three of our Motley Fool contributors think oil-and-gas company MPLX LP (MPLX 0.74%), telecom giant AT&T (T 2.02%), and mortgage real estate investment trust Annaly Capital Management (NLY 0.15%) are top contenders in the world of high-yield stocks. Here's why you should consider adding these companies to your portfolio.
High yield + stable business + growth prospects = great dividend stock
Tyler Crowe (MPLX LP): A stock that has a yield above 7.5% is going to raise several red flags for investors, especially when that stock intends to grow its payout 10% annually. If you look into the financials and business plan for MPLX, though, those concerns about its yield may not carry much weight.
When looking at high-yield stocks in the oil and gas pipeline, processing, and logistics business, three critical factors should stand out to investors: a company's debt leverage, its ability to cover its payout with generated cash, and management acting as good stewards of shareholder capital. MPLX passes all three of these tests with flying colors.
As of the company's most recent quarterly report, MPLX reported a debt-to-EBITDA ratio of 3.8 times, which is a low level of debt for a company in this industry and shows the company has some room to use debt to grow the business. It also reported a distribution coverage ratio (cash the company can distribute after operating costs and maintenance capital expenses divided by total cash distributed) of 1.47 times. By master limited partnership standards, this is a very healthy ratio and means that MPLX is retaining about $1 billion in cash on an annual basis to reinvest in growth. These metrics suggest that the company is in good financial shape.
This last factor is hard to measure, but it is probably the most important for long-term investors. Both its financial strength and its payout policy are evidence that management is working with investors in mind. A greater sign of confidence was management's decision to buy out its general partner's stake in the business and eliminate a more complex corporate structure. This was proof that all shareholder interests are aligned.
These three elements make the company a great business in which to invest, and its high yield and fantastic growth prospects make it a high-yield stock that investors should seriously consider today.
The highest yield in years
Tim Green (AT&T): Shares of telecom giant AT&T are down about 20% so far this year, which is great news for dividend investors looking for a sky-high yield. AT&T stock now yields nearly 6.5%, a level that was last breached in early 2010.
There are certainly some legitimate reasons why the stock has been selling off. For one, AT&T's mega-acquisition of Time Warner carries some major risks. The deal gave AT&T an extensive list of media assets, including HBO, but the price was paid with a mountain of debt. AT&T's debt totaled $183 billion at the end of the third quarter. The company generates plenty of free cash flow -- roughly $26 billion is expected in 2019. But the greater the debt, the more fragile the company.
Taking on so much debt to buy Time Warner could pay off if the company can successfully harness its new assets to become a major player in the streaming business. On top of its HBO streaming service, plans for a three-tier subscription service from WarnerMedia are in the works for late 2019. AT&T will be competing with market leader Netflix as well as with Disney's planned streaming service, but it now has the content to potentially make it work.
With a beaten-down price and a 6.5% dividend yield, AT&T stock is worthy of a place in your portfolio. But because of the risks created by the company's massive debt load, it may be best to keep the position small.
A double-digit yield with staying power
Sean Williams (Annaly Capital Management): There's arguably no industry in the market that's more unpopular from a dividend perspective than mortgage real estate investment trusts, or mREITs. Yet from my perspective, mREITs -- or more specifically Annaly Capital Management, the mREIT that's been around longer than its peers -- are highly underappreciated.
mREITs like Annaly Capital make their living by borrowing money at short-term lending rates and purchasing assets with a long-term yield. The difference between this long-term rate and short-term rate comprises the margin that allows mREITs to be profitable. Generally speaking, when interest rates are dropping, the gap between long- and short-term rates widens, offering mREITs an opportunity to make more money. Conversely, when interest rates rise, net interest margin tends to shrink, leading to lower profitability. Since REITs are required to pay out most of their earnings as a dividend in order to avoid normal corporate income taxes, lower profitability would translate to a smaller dividend. That's why they've been under pressure the past couple of years.
While it is possible that Annaly's 12.1% dividend yield will be cut modestly in the future, plenty of factors suggest its payout may also be sustainable.
The biggest wild card here is the Federal Reserve. What crushes mREIT profits is when the Fed gets overly aggressive with interest rate hikes. However, the Fed has been methodically raising rates, if not walking on eggshells while doing so. This has given Annaly and its peers plenty of time to reposition their assets to account for higher rates. In fact, the company's net interest margin expanded three basis points to 1.50% during the third quarter from the year-ago period. With no urgency on the horizon from the Fed, there's no reason to believe Annaly and its management team can't adjust.
Investors may also be overlooking the fact that most of Annaly's assets (i.e., mortgage-backed securities) are agency-backed loans. This just means they're protected from default by the federal government. This protection, while weighing down the yields the company receives on its longer-term assets, does allow it to use leverage to its advantage. This leverage, when combined with the methodical increase in interest rates by the Fed, has made Annaly a profit-producing machine. You'd struggle to find a more attractive income stock.