Are you looking for a relatively reliable way to grow your portfolio? Buying stocks that pay regular dividends and reinvesting those dividends is a tried and true method proven to work over time.
Of course, the amount of time it takes to realize huge returns shortens when your stocks pay higher dividend yields. Annaly Capital Management (NLY 0.94%) offers such a high yield right now that reinvesting the payouts it delivers each quarter could double your original investment in four short years.
Why the ultra-high yield?
Annaly Capital Management offers a tantalizing 20.1% yield right now because the stock is getting hammered. In a nutshell, the market is worried about the Federal Reserve's efforts to reduce inflation by raising interest rates and the effect this is having on Annaly's rate-sensitive business.
Annaly Capital Management is a real estate investment trust (REIT) that buys mortgage-backed securities (MBS) and not physical property. Instead of collecting rent payments, mortgage REITs earn a profit on the spread between the interest income their long-term MBS portfolios provide and their shorter-term financing costs. The market's worried that Annaly's borrowing expenses will exceed interest income before the company has a chance to update its MBS portfolio.
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Income investors feel generally comfortable with Annaly shares in their portfolio because the company focuses on agency-backed securities that have cash flows guaranteed by the U.S. government. While Annaly's incoming cash flows are predictable, its funding costs have risen sharply this year. The high side of the Fed's target rate range has exploded from 0.5% in March to 3.25% following the latest meeting in September.
The Federal Reserve has a mandate to continue raising rates until it tames inflation, and nobody knows when it will be able to quit. That means the payouts you receive from Annaly might not be as reliable as you want them to be.
The first domino to fall?
On Sept. 29, 2022, shares of Annaly Capital Management fell about 10% overnight in response to an announcement from Invesco Mortgage Capital (IVR -1.39%), one of Annaly's industry peers. Invesco Mortgage cut its quarterly dividend payout from $0.90 per share to $0.65 per share.
Invesco Mortgage Capital said earnings are still strong but the company wants to improve its capital structure. The mortgage REIT had a debt-to-equity ratio of 4.7 as of Aug. 31, 2022. At a glance, this ratio looks significantly better than that of Annaly Capital Management, which reported a debt-to-equity ratio of 5.4 at the end of June.
Reason to buy
Annaly Capital Management and Invesco Mortgage Capital are both mortgage REITs, but their lenders don't perceive them in exactly the same light.
Mortgage REITs use the value of their MBS portfolios to secure relatively low-interest short-term loans. When lenders lose confidence in the value of an mREIT's portfolio they start demanding more cash as collateral. In the early days of COVID-19, Invesco had to severely slash its dividend and liquidate portions of its portfolio to satisfy lenders. Annaly didn't escape entirely unscathed, but it only lowered its payout by 12% per share and it hasn't budged since.
NLY Dividend data by YCharts
The Fed is expected to raise rates again at least a couple more times this year then hopefully relax in 2023. If Annaly can weather the storm, investors who buy the stock on the dip could be rewarded over time. A higher-interest-rate environment should widen the spread between the mortgage-backed securities Annaly adds to its portfolio and its cost of capital.
Before buying this stock, you need to realize that it could fall hard if the Fed keeps turning the screws in 2023. If that's a risk that you're willing to take, making this stock a small part of a well-diversified portfolio probably isn't a bad idea.
