Investors focused on dividend stocks soon learn that this axiom provides fair warning: Sometimes dividend yields are too good to be true.
Income investors scouring the equity markets these days looking for yield would do well to do a reality check and better determine if some of the great dividends popping up are actually sustainable. Too often a stock gets beaten up, the price falls, and the historical dividend looks great.
But as they say, past performance is no guarantee of future performance. It is critical to keep this in mind when thinking about dividend stocks. Let's take a look at two stocks right now that offer up a good lesson on the pitfalls of high yields.
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Brokers are better, but the mortgage origination business is struggling
UWM Holdings (UWMC -2.21%) is a leader in the mortgage origination arena. It is no secret that the mortgage origination business struggled in 2022. After feasting on easy refinance activity during the COVID-19 pandemic, the Federal Reserve aggressively hiked rates, which turned off the spigot on these types of loans. After all, nobody is going to refinance a 3.5% mortgage when rates are 6%.
UWM is betting that its business model is superior, which will allow it to take market share from other bankers. UWM is in the wholesale mortgage banking business, which is different than most other models. Wholesale bankers use a network of mortgage brokers who source loans. Brokers are free agents who can use any mortgage bank to get the best deal for a borrower. This aspect of the business is the basis for UWM's motto "Brokers Are Better."
That said, the mortgage industry is facing two headwinds. First, refinance activity is dead. Second, home sales are collapsing due to affordability constraints. Home prices rocketed during the pandemic as rates encouraged the purchase of second homes and investment properties. Between rising rates and inflated home prices, the first-time homebuyer has been largely shut out of the market. The first-time homebuyer is critical to the entire housing ecosystem. You can see how home sales collapsed during 2022 as the Fed began hiking the federal funds rate.
US Existing Home Sales data by YCharts.
UWM pays a quarterly dividend of $0.10 per share, which works out to be an annual yield of 11.4%. A yield that high is stratospheric for a mortgage banker. Wall Street analysts see the company earning just $0.19 per share for all of 2023, so the annual dividend will end up being over twice the expected earnings. This is a serious red flag for UWM.
Mortgage REITs are cutting dividends en masse
Annaly Capital Management (NLY 0.40%) is a mortgage real estate investment trust (REIT) that has a number of different business lines. It owns mortgage-backed securities, which are guaranteed by the U.S. government, and it also originates mortgages as well as holds mortgage servicing rights. Annaly is probably one of the most well-run mortgage REITs out there.
Like the mortgage originators, last year was awful for the mortgage REIT space. Rising rates are never good for fixed-income investors, and mortgage REITs have suffered from mortgage-backed security (MBS) underperformance versus Treasuries. This underperformance has translated into declining book values per share.
Many of Annaly's peer group have been cutting dividends. MFA Financial (MFA -1.45%), PennyMac Mortgage Trust (PMT 2.52%), Two Harbors (TWO -0.88%) have all made dividend cuts recently. Mortgage REITs generally like to have their dividend yields in the low double-digit range, and they will adjust accordingly to keep them there. Annaly is trading with a dividend yield of 15.9%, which is on the high side.
While nobody likes to cut their dividend, the reality is that if everyone else in the sector is doing it, it is an opportunity to follow suit. For Annaly, if mortgage-backed securities begin to outperform Treasuries (which they probably will), a dividend cut might be avoidable. That said, the risk of a cut is there, and investors should keep that in mind.
