Dividend stocks are the foundation to which many great retirement portfolios are built. Generally speaking, the higher the dividend, the more of an allure that stock tends to hold for income investors.
However, there's a give-and-take to this concept. While a high-dividend stock can quickly double your money compared to a 2% or 3% annual yield, it can also quickly destroy shareholder value if the dividend proves unsustainable.
In today's market, there are more than 100 stocks that have delivered a double-digit (10%+) yield over the trailing-12-month period, but not all of these double-digit dividend yields are sustainable.
Recently, we asked three of our analysts to offer up a double-digit dividend stock that was in danger of cutting its payout. Here's what they had to say.
Double-digit yields are certainly enticing because they can double your money in as little as seven years or less if they're sustainable. Unfortunately, that's not often the case.
One such double-digit dividend yield that could soon be facing the guillotine is mortgage real estate investment trust (mREIT) Annaly Capital Management (NYSE: NLY).
Mortgage REITs are an interesting group in that they benefit when interest rates are falling or near record lows. Low interest rates allow them to borrow at near-record low levels and lend money at a higher rate, thus pocketing the difference. As rates begin to rise, the net interest margin that mREITs take advantage of gets squeezed, resulting in lower net interest margins -- and profitability, in many instances.
Annaly Capital Management is an agency-only mREIT, meaning it invests solely in assets that are backed by the U.S. government. The upside to this is it allows Annaly to really use leverage to its advantage, since any agency-backed defaults within its portfolio would be protected by the government. On the flip side, the price for this safety is a dramatically lower net interest margin than its non-agency mREIT peers, who are more exposed to default risk.
The big concern for Annaly is that the Federal Reserve has been very openly hinting that a rate hike is likely around the corner. As rates rise, Annaly's profits will likely fall, hurting its distribution capacity. Currently paying $1.20 per share each year in dividends, Annaly is only expected to earn $1.09 in EPS for 2015 and $1.03 in EPS for 2016. As its profits shrink, I would expect its dividend to follow.
One quick note: Even with declining profits and a potentially shrinking dividend, Annaly has regularly outpaced the broad-based S&P 500 in terms of dividend yield many times over. Thus, long-term investors may want to rethink the need to run from Annaly as rates rise, as it should still provide ample income for investors over the long haul.
In December, Prospect Capital (NASDAQ: PSEC) slashed its monthly dividend from an annual rate of $1.32 per share to $1.00 per share. That cut was intended to better align its dividend with earnings, but it may not have been deep enough. I think another dividend cut may be in the cards for 2015.
Prospect Capital currently plans to spin off assets to investors and create four publicly traded companies from one. Assuming that plan goes through as designed, I suspect it will result in a reduction of book value and earnings per share due to new operating costs and incentives to bring in new investors. If the spin-off doesn't happen, Prospect Capital's recent earnings and portfolio performance give little reason to think the dividend is inherently safe. It earned just $0.24 in net investment income in the most recent quarter, below its payouts, which tally to $0.25 quarter.
Furthermore, the company continues to spin its wheels when it comes to following through on promises to improve its earnings power. It outlined a plan to sell its lower-yielding investments and rotate into higher yielding investments, but it only recently registered its first sale -- nearly a full year after it detailed its plans to investors.
Given its slow movement on asset sales, its complicated spin-off plans, and its recent portfolio performance, I think the dividend is certainly in danger of taking another hit. Buyer beware.
Royalty trusts have attracted income investors lately with their huge dividend yields, but there are many people who don't really understand the nature of royalty trusts and why their distribution yields can be misleading. For instance, SandRidge Permian Trust (NYSE: PER) currently has a yield of 35% based on its payouts over the past 12 months, which makes it look like a dream come true for dividend investors.
But there are a couple of things investors need to know before they buy shares of SandRidge Permian Trust expecting these yields to continue.
First, this particular royalty trust is tied to particular properties, where SandRidge has already drilled all of the required wells under the trust arrangement. That means from now until its dissolution in 2031, the trust will essentially be a declining asset. More importantly, the SandRidge Permian Trust has a special subordination provision that pays higher quarterly income to unitholders only through the end of this year. In 2016, the subordinated units SandRidge owns will convert to common units, and that will reduce the share of profits that trust holders get, cutting the distribution amount.
SandRidge Permian Trust isn't necessarily a bad investment, but you shouldn't expect a dividend windfall, either. With future cuts likely, investors have to run their own numbers to see if the royalty trust has a risk-reward ratio they like.