When it comes to investing for income, monthly dividends certainly have their advantages. Aside from the obvious benefit of receiving a more frequent stream of income, monthly dividends can actually lead to better investment returns over the long run.
One company with monthly dividends is ARMOUR Residential REIT (NYSE:ARR), a real estate investment trust specializing in mortgages and mortgage-backed securities. And, not only does ARMOUR pay monthly, but at nearly 15% it has one of the best yields in its sector.
Why do we care that ARMOUR pays its dividend monthly? How can ARMOUR afford to pay out so much, and is it sustainable? Also, what are the risks involved with owning such a high-paying mortgage REIT like this?
The long-term benefits of monthly dividends
If you rely on your investments for current income, the benefits of monthly dividends are obvious: you get a payday once a month rather than every three months.
However, if you are buying dividend stocks for the long term, there is another not-so-obvious benefit to consider. Specifically, the more frequent compounding of monthly dividends can produce higher returns over the long run.
Consider a stock that pays a 15% dividend, like ARMOUR does. Well, assuming you reinvest all dividends, a quarterly dividend actually translates to an annual return of about 15.9%. However, when compounded monthly this actually rises to about 16.1% on an annualized basis. This might not sound like much of a difference, but can have quite an impact over the long run.
In fact, over a 30-year time period this small difference in returns can mean an extra $48,000 on an initial $10,000 investment. That's why monthly dividends are so nice.
ARMOUR: what it does and how it makes so much money
Basically, ARMOUR (and other mortgage REITs) makes its money by borrowing money at a low interest rate to buy mortgage-backed securities that pay a higher rate, and the profit comes from the spread between these two interest rates.
Each specific company has its own preference in regards to the type of mortgages it holds, and ARMOUR's focus is on shorter-term (15 and 20 year) fixed rate mortgage securities issued by Fannie Mae, Freddie Mac, or Ginnie Mae. And, because short-term mortgages generally come with lower interest rates, ARMOUR's current portfolio averages a 2.86% yield. So, how does it make enough money to cover a 15% dividend?
Through the power of leverage, mortgage REITs can multiply their profits (and risk) several times over. ARMOUR uses a relatively high 7.9-to-one leverage ratio, meaning that for every $1.00 in assets the company has, it borrows about $7.90.
And, since ARMOUR's cost of borrowing money is just 1.40% on average, its profits come from the 1.46% spread between this rate and the interest rate it collects from its investments.
You can buy it at a discount
So, ARMOUR's return should theoretically be around 11.5% (1.46% interest rate spread times 7.9-to-one leverage), well short of the 15% it pays out.
However, bear in mind that the leverage ratio is stated relative to the shareholders' equity, which as of the most recent quarter was $4.90 per share. So, when accounting for this "discount", ARMOUR's returns are actually closer to 14%. While this is still not quite enough to cover the dividend, that doesn't necessarily imply that a dividend cut is on the way.
Mortgage REITs' income can carry over from quarter to quarter, so a small shortfall isn't necessarily an issue. For example, ARMOUR produced earnings of $0.13 per share during the second quarter; two cents shy of the dividends it paid out. However, earnings estimates for the current quarter average $0.15, and are actually as high as $0.23, so if the company earns more than it paid out, it can be used to make up for the previous shortfall.
And, as of this writing, ARMOUR trades for about 26% below its book value of $4.90 per share, meaning that you can buy the company's assets for substantially less than they're worth.
Does the risk justify the reward?
Well, naturally any company that uses such a high leverage ratio to fund its business has some level of risk.
Specifically, ARMOUR is very susceptible to interest rate fluctuations. ARMOUR borrows on a relatively short-term basis, so any interest rate spikes could erode the spread fairly quickly. However, recent economic signals point toward interest rates remaining low for the near future.
No company that pays nearly 15% is without risks. However, in ARMOUR's case the risk may be justified by the reward, as well as the fact that shares are selling for a very nice discount right now.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.