Often enough, a stock sporting a high dividend yield is a red flag that the company may be in trouble. It's an indication that investors are beginning to suspect the dividend is going to be cut, especially if the stock's yield is an outlier compared to other companies in the same business sector.
That said, there are some types of stocks that do pay a high yield because of the nature of their business, and it is not a red flag. Real estate investment trusts (REITs) routinely have high dividend yields, and Annaly Capital Management (NLY +0.13%) is one such stock with a yield that appears high but is actually quite safe and manageable.
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A source of high yields
REITs generally have higher than normal yields because they are required to distribute the majority of their earnings via dividends in order to maintain their exemption from corporate taxes. Real estate investment trusts generally follow a landlord/tenant model, where the REIT develops a rental income-producing property such as an office building, apartment complex, or shopping mall.
Annaly Capital is a mortgage REIT, which is different than the typical REIT. Mortgage REITs don't invest in real property; they invest in real estate debt. And Annaly is an agency REIT, which means it focuses on mortgages that are guaranteed by the federal government. This means that the company takes limited credit risk, but it has more interest rate exposure, so it must control its interest rate exposure tightly. In many ways, mortgage REITs resemble a bank more than the typical REIT.
Annaly purchases mortgage-backed securities that have yields around 3% to 4% and then uses leverage (in other words, borrowed money) to turn the portfolio into something that supports a near-10% dividend yield. The mortgage REIT is doing what an individual investor does when using margin. Say you want to invest $1,000 in a stock. You can use margin to buy $2,000 worth of stock. A mortgage REIT is more likely to invest $1,000 and use leverage to buy $7,000 worth of mortgage-backed securities. That use of leverage can become a risk when the securities markets have bouts of illiquidity. We saw that happen last year during the early days of the pandemic. Just about every mortgage REIT was forced to cut its dividend, but Annaly cut its payout by the least.
Annaly is adding its exposure to credit
Annaly operates three basic investment strategies. Its agency strategy focuses on purchasing mortgage-backed securities guaranteed by the U.S. government. The Residential Credit Group focuses on non-guaranteed mortgages, while middle-market lending focuses on smaller businesses that are backed by private equity firms. Annaly recently sold its commercial real estate business.
In the first quarter, Annaly earned 3.76% on its assets and paid out 0.42% in interest expense. This gave the company a net interest spread of 3.34%. Leverage (or the amount of borrowing to support these assets) fell markedly over the past year, going from 6.4 times to 4.6 times. Leverage is a double-edged sword: It can magnify gains on the upside and exaggerate losses on the downside. In addition, if Annaly is using mark-to-market leverage, it can be forced to put up additional capital. Mark-to-market leverage costs less, but it is a secured loan, and if the value of the collateral falls, the bank will ask the mortgage REIT to post more cash.
Annaly is increasing its exposure to mortgages that are not guaranteed. These are loans that don't meet the requirements for a qualified mortgage that can be insured by the government. They often are targeted toward professional real estate investors and self-employed borrowers, and they carry higher interest rates than the typical agency mortgage. These loans are not subprime loans like we saw in 2005-2006. They are often highly overcollateralized, and the borrower demonstrates the ability to pay either with bank statements or the expected income on the property.
As Annaly builds out this part of its business, it should see increased interest margins, which will reduce the need for leverage. It currently pays a $0.22 per share quarterly dividend, which gives the stock a dividend yield of 9.5%. In most other industries, a 9.5% dividend yield is a huge red flag, but in Annaly's case, it is normal. Since it pays such a high yield, it won't be the most exciting stock to watch (don't go looking for spiffy pops in this sector), but for income investors, it is a yield you can trust.
