Mortgage real estate investment trust (mREIT) Annaly Capital Management (NLY 0.55%) announced on its recent earnings call that it plans to cut its dividend, which currently has an eye-popping yield of roughly 16%. Management said they expect to bring the dividend down to a more "sustainable yield" of 11% to 12%.
While some may not have seen it coming, I think many investors questioned the high yield, particularly given soaring interest rates made the environment very difficult for mREITs. But is the upcoming dividend cut just the beginning? Will there be more to come?
Why Annaly's dividend was cut
Annaly is largely in the business of investing in government-guaranteed mortgage-backed securities (MBS), which are filled with pools of mortgage loans. Annaly also invests in other residential credit products and mortgage servicing rights.
Image source: Getty Images.
While government or agency-backed MBS are very safe from a credit perspective (i.e., missed mortgage payments), they are vulnerable to interest rate risk. As mortgage rates skyrocketed well in excess of Treasury yields, MBS bond values got crushed, resulting in huge unrealized losses and declines in Annaly's book value, or equity, which mREITs trade relative to. For instance, at the end of 2021, Annaly had a book value per share of $31.88 and total unrealized gains of more than $958 million. At the end of 2022, the company had unrealized losses of more than $3.7 billion and book value per share of $20.79.
Annaly also faces pressure on its earnings because rising rates lead to higher funding costs for its asset purchases such as agency MBS. Funding costs rose by more than 65% in the fourth quarter alone, and while the yields Annaly makes on its securities and loans are rising as well, it was not enough to offset the sharp spike in funding costs.
Earnings available for distribution (EAD) per share, which is a key number to watch when it comes to the company's ability to cover its dividend, has fallen from $1.14 per share to $0.89. Annaly's quarterly dividend is $0.88, so it just barely covered it in Q4.
The environment could also remain tough. While the softening of inflation in recent months has led many to believe the Fed is almost done with its aggressive rate-hiking campaign, it is by no means a certainty. Inflation may remain more persistent than the market thinks and the Fed may have to raise rates to higher levels than imagined or hold them higher for longer. This may lead to higher mortgage spreads and would certainly lead to elevated funding costs.
On Annaly's recent earnings call, executives said they expect EAD to continue to face pressure. One big reason is that funding costs have not peaked yet from the rate hikes the Fed has already done. Funding costs tend to move higher on a slight lag and the Fed hasn't stopped raising rates since it started last March, so I suspect that interest expenses will continue to rise faster than the yields on Annaly's interest-earning assets.
Are more dividend cuts only a matter of time?
If Annaly were to take down its dividend to a 12% annual yield, that represents a quarterly dividend of roughly $0.62 based on Annaly's current share price of $20.74. Dividend cuts after that aren't a given but could certainly happen, especially if inflation stays hot and the Fed feels it needs to keep raising interest rates. That will continue to pressure Annaly's EAD and may make it difficult to cover the 11% or 12% yield. Make no mistake, despite the alluring yield, Annaly remains a very risky dividend stock.
