There is no such thing as a perfect investment -- all stocks come with trade-offs. But some trade-offs are just too extreme to bother with.
Many ultra-high-yield dividend stocks fall into this category. Contrary to the safe-and-steady image you may have of passive income investments, an unusually high yield can be a warning sign. That's the story behind Annaly Capital (NLY 1.02%) and its gargantuan 13.5% dividend yield. Most dividend investors should avoid it, and for very good reasons. But for Bank of Nova Scotia (BNS 0.71%) and Realty Income (O -0.17%), the story couldn't be more different. Here's what you need to know about these three ultra-high-yield stocks.
Annaly Capital: A tale of dividend woe
Before explaining why Annaly isn't a great dividend stock, it should be noted that it isn't really designed to be owned by dividend investors. The company is meant to be plugged into an asset allocation model, providing large investors like insurance companies with direct exposure to mortgage securities. It's just that, for tax reasons, Annaly is structured as a real estate investment trust (REIT), so it pays out most of its earnings as dividends.
Image source: Getty Images.
Large investors simply reinvest the cash they collect and look at total return. But the huge 13.5% dividend yield isn't really a number small investors can count on, especially if they are trying to live off the income they generate from their portfolios. Why is this so? Because over the past decade, the dividend has been cut multiple times. Mortgage REITs are highly sensitive to changes in interest rates, investor sentiment around mortgage securities, and the housing market, among other things, so financial performance can be volatile.
Annaly's stock has basically followed the dividend lower, leading to a situation in which a small investor would have been left with a smaller income stream and less capital. That's about as bad as it can get for a dividend investor.
Unless you are willing to bet that the future will be drastically different from the past, you are better off avoiding Annaly. But all high-yield stocks aren't the same.
Realty Income is the Monthly Dividend Company
While Annaly owns mortgage securities, Realty Income actually owns a portfolio of physical commercial properties. They are leased out to tenants, just like you might do if you owned a rental property. Realty Income's dividend has been increased annually for 29 consecutive years, and it's paid out monthly instead of quarterly -- in fact, the REIT has trademarked the nickname "The Monthly Dividend Company."
In fairness, the dividend tends to grow pretty slowly, at around 4.3% a year over the past 29 years, but Realty Income has proven to be a highly reliable dividend payer. Now add in a hefty 5.5% dividend yield, which is toward the high side of the historical range over the past decade. That suggests that the stock is cheap today. The dividend seems safe for other reasons, too, given the fact that Realty Income is the largest player in the net lease space (giving at an advantage when it comes to accessing capital and inking big deals) and it has an investment grade rated balance sheet.
If you are looking at Annaly because it is a REIT, look at reliable dividend payer Realty Income instead.
Scotiabank is improving its performance and supporting its dividend
Another option, if you are simply looking for a financial stock to buy, is Scotiabank, as the Bank of Nova Scotia is known. It is one of Canada's largest banks in a local industry that is highly regulated. In fact, there's so much regulation that the top banks pretty much have protected market positions. The heightened regulation has also instilled a conservative ethos into Canadian banks like Scotiabank. This isn't a bank that's likely to take on huge risks -- unlike some major U.S. banks, Scotiabank didn't cut its dividend during the Great Recession.
But what's behind Scotiabank's huge 6.8% dividend yield? Two things. First, while most of its Canadian peers have looked to the U.S. market to grow, Scotiabank has focused more on Central and South America. Those are inherently riskier regions in which to operate. And, second, Scotiabank has lagged its peers on key financial metrics, like earnings growth, return on equity, and non-interest revenue growth. So there are reasons why Scotiabank is one of the highest-yielding bank stocks you can buy. However, management is working on improving its relative performance, via things like improving its cost structure and bringing in more core deposits, which are a relatively inexpensive funding source.
But more to the point here, when confronted by analysts about the high yield, management was pretty matter-of-fact about the situation. To summarize, the payout ratio is high right now, but management doesn't think there's any reason to worry. And, in time, management expects the steps it is taking to improve its relative performance to also reduce the payout ratio back into a more comfortable range. If you can handle collecting a big yield while a company with a hundred-year history of reliably paying dividends works through a rough patch, then Scotiabank might be for you.
Tread carefully with high yields
Far too often, an unusually high yield is a sign of risk that gets ignored by yield-hungry investors. So make sure you dig into the story behind the dividend stocks you buy, a move which would likely lead you to steer clear of Annaly Capital. But a high yield can also be an opportunity, as it appears to be with Realty Income and Bank of Nova Scotia (aka Scotiabank). When you examine the stories behind these two reliable dividend stocks, they start to look more attractive, not less.
