Finance can be a complex business, but some companies try to keep things as simple as possible. That's exactly why investors will like high-yield Canadian banks Bank of Montreal (BMO -4.82%) and Toronto-Dominion (TD -0.59%) despite the risk of a recession. That said, Annaly Capital Management (NLY 0.08%), which buys and sells mortgages, is a name that most dividend investors will likely want to avoid. Let me explain.
The bad news and the good
Recessions are bad for banks because they lead to reduced demand for loans (like mortgages) and often lead to increases in loan delinquencies. This is why, despite the benefit of rising interest rates which allow banks to charge more for loans, investors are so downbeat on bank stocks today. The negative sentiment pushed the dividend yield on Bank of Montreal, or BMO as it's more commonly known, and Toronto-Dominion, or TD, to 4.8% and 4.2%, respectively. Those are very attractive yield levels for what are very conservative investments.
The most important figure to note here is the Tier 1 Capital Ratio, which is a measure of how well a bank can handle adversity. BMO's Tier 1 ratio is 15.8% while TD Bank comes in at 14.9%. In and of themselves, those are pretty good numbers, but the real takeaway is that they are the two best Tier 1 ratios in North America. Put simply, BMO and TD are the best-positioned banks you can buy if you are worried about a recession. And that's a real worry, given that there have already been two consecutive quarters of negative U.S. gross domestic product, which is Wall Street's unofficial indicator of a recession.
That said, they both have extremely strong positions in their home market of Canada. This country has a long history of regulation that has left the banking industry operating both conservatively and with an entrenched handful of industry leaders (TD and BMO are both in that group). On top of that, these two banks have been expanding south into the U.S. market, which presents more material growth opportunities. So they have a solid core and a chance to layer some growth on top of that while you collect generous dividends from banks that are operating with a safety-first mentality. That sounds like a winning proposition for long-term investors.
Danger signs for Annaly Capital
BMO and TD try to keep things fairly simple, focusing most of their energy on core banking services. That includes deposit accounts, checking, and mortgage loans. On that last score, Annaly Capital Management blurs the lines a little. It buys mortgages that have been grouped into pools, called collateralized mortgage obligations (CMOs). These trade on the market based on supply and demand. Annaly uses leverage to enhance its returns, often with its CMO portfolio acting as collateral for the loans it takes. It can be a high-risk approach, which helps explain why Annaly tends to have a high dividend yield all of the time.
Right now the yield is a whopping 21%. That's a level that strongly hints at a potential dividend cut, as investors often sell off the stock of companies that they fear will trim well before the trimming takes place. A cut, meanwhile, wouldn't be out of character here; the dividend has been heading lower for years, dragging the share price down with it. But, since the stock has been falling, the yield has been in double digits the entire time.
For investors seeking reliable dividend income, Annaly just isn't the type of stock you'll want to own. Note, too, that the real estate investment trust (REIT) just went through a reverse stock split. Reverse stock splits can be a sign that things aren't going particularly well for a company. Add it all together and most investors will probably want to stay on the sidelines here, especially since mortgage delinquencies could be headed higher if there's an official recession.
Bear markets are often a good time to start looking for new investments because stocks can get pretty cheap. But they aren't necessarily a time to be overly aggressive when selecting investments. In fact, the best course of action is usually to buy industry-leading companies at attractive prices, like BMO and TD. Taking on too much risk, which is likely what you'd be doing if you bought the over 20% yield on offer from Annaly, could easily end up burning you in the end.