The mortgage real estate investment trusts (mREITs) Annaly Capital Management (NLY 1.33%) and AGNC Investment Corp (AGNC 0.99%) have become popular stocks since the pandemic due to their high dividend yields.
Annaly currently has an annual dividend yield of more than 17%, while AGNC's is about 13%. These yields are so good that if you put your money into either stock for a year, your returns will beat the broader market on average.
But the rule for dividends is that if the yield looks too good to be true, then it probably is. With that said, let's take a look at which mREIT has the more sustainable dividend.
A chaotic time for mREITs
MREITs are complex companies to analyze, but in general, both Annaly and AGNC are largely in the business of using leverage to invest in government-guaranteed (or agency) mortgage-backed securities (MBS), which are pools of mortgage loans that are securitized and then sold to investors. Also, under the REIT designation, both Annaly and AGNC must pay out at least 90% of their taxable income to qualify for special tax advantages.
Image source: Getty Images.
While agency MBS don't face many risks from a credit perspective, they are bonds and are, therefore, subject to interest-rate risk. Bond values trade inversely to bond yields, which are heavily influenced by the Federal Reserve's overnight benchmark lending rate, the federal funds rate.
As rates and bond yields have soared over the last year, bond values have gotten crushed, particularly when you think about MBS and how mortgage rates at one point topped 7%. Because bonds are marked-to-market each quarter as unrealized gains and losses, Annaly and AGNC have seen their book value or equity take a hit. Keep in mind that these are just paper losses. Both Annaly and AGNC should recoup most, or even all, of these losses as rates stabilize and bonds mature.
But lower book values have led to lower share prices because mREITs typically trade right around their book values. This is why dividend yields have been so elevated at these two companies since the pandemic.
Earnings under pressure
Higher interest rates have not only hurt mREIT book values, but they've really started to hurt earnings as well, mainly because the cost of the debt that both companies use to fund their bond purchases and other assets has increased. Considering Annaly and AGNC pay out so much of their earnings in dividends, if earnings face pressure, then dividends are likely to as well.
Both companies have now announced some kind of dividend cut since the pandemic. In April 2020, AGNC trimmed its dividend, which it pays out monthly, from $0.16 per share to $0.12. Annaly also cut its quarterly dividend around that time by 12% to $0.22.
More recently, however, AGNC looks to have done a better job protecting against interest-rate risk. At the end of 2022, AGNC had a hedge ratio of 124% of its liabilities, which essentially means it has purchased derivatives such as interest-rate swaps that protect it or hedges against higher rates raising its cost of debt. AGNC's funding costs have risen but at a more muted pace. In the fourth quarter, AGNC saw the earnings it can use to cover its dividend fall from $0.84 per share in the third quarter to $0.74 per share.
Meanwhile, Annaly's hedge ratio at the end of 2022 was 107%, and the company has seen a more meaningful step up in funding costs. Its earnings available for distribution have fallen from $1.06 in Q3 to $0.89 in the fourth quarter, which is just a penny above its current quarterly cash dividend. In its Q4 earnings call, Annaly's management team announced its intention to cut its annual dividend yield from 16% at the time to around 11% or 12%.
Which dividend is more sustainable?
Annaly had a higher dividend yield than AGNC, so the cut will put the two on more of an even playing field.
But even after this cut, which, at a 12% annual yield would put Annaly's quarterly dividend around $0.62 per share, the dividend may not prove sustainable. Management told investors that earnings available for distribution could face further pressure in the coming quarters.
That's why I think AGNC's dividend is currently more sustainable, given that the quarterly dividend of $0.36 is being supported by $0.74 of earnings that can be distributed to shareholders in Q4, which is better coverage.
That said, both of these dividends could face further pressure if inflation proves stickier than anticipated and the Fed decides to raise rates higher than expected.
