Annaly Capital Management (NLY -0.27%) is one of the highest-paying dividend stocks, with a yield of more than 16%. The double-digit dividend yield of this mortgage real estate investment trust (mREIT) may be attractive in today's high inflation bear market, but is its dividend worth the risk? Let's find out.
Economic pressures are hurting this REIT
Annaly Capital primarily invests in agency mortgage-backed securities (MBSs) that are guaranteed by the federal government. Additionally, it invests in a small but growing number of non-agency-backed securities (non-QM), like jumbo loans or real estate loans on rental properties. And it earns income from mortgage servicing, which is the processing and management of mortgage accounts in return for fees. As of the third quarter of 2022, the company held roughly $86.2 billion in assets in its portfolio.
Mortgage REITs rely heavily on short-term debt to fund their long-maturity assets. At the start of 2022, the federal funds rate, which sets the cost for short-term borrowing, was at 0.25% -- making Annaly's cost of capital extremely cheap. So far this year, the Federal Reserve has raised the fed funds rate six times, which has seriously hurt Annaly's earnings. Rising interest rates negatively impact a mortgage REIT's profitability because it narrows the margins on its spread between the interest its earns from its loans and its cost of borrowing.
In the third quarter of 2022, Annaly's net interest spread fell by 1.37 percentage points from the quarter prior. Its net interest income, which makes up the bulk of its revenue, fell by 41% from last quarter, and 23% from last year. As a result, the company reported a per-share loss of $0.70, its first negative quarter in more than a year.
Its agency-backed mortgages carry little credit risk for the company. If a borrower defaults, the government guarantee acts as a backstop. However, demand for these assets has receded over the last year after the Fed stopped purchasing MBSs. Treasury yields have also exceeded MBS yields, further diminishing demand and reducing the pool of buyers for Annaly's assets. In turn, its asset values have fallen and its per-share book value sank by 18% in the third quarter.
Its non-QM loans aren't affected as much by rising interest rates, because their net interest spread is wider. However, it does expose Annaly Capital to credit risks. Because these loans aren't guaranteed by the government, if the borrower stops paying it could lead to loan losses for the company.
If economic conditions worsen, so does the outlook for Annaly
Annaly Capital now has an 16% dividend yield, which is more than 10 times the average dividend yield of the S&P 500. Maintaining such a hefty yield when you're operating at a net loss isn't sustainable over the long run. One-quarter of net losses doesn't mean its dividends will be cut tomorrow. But if economic conditions that lead to rising interest rates and lower demand for mortgage-backed securities don't improve, it's unlikely Annaly's earnings will rebound.
It's very probably that the Fed will continue to raise rates until inflationary pressure wane. This means investors should prepare for Annaly's margins to further narrow. There's also a lot of talk of a recession looming, which would certainly make Annaly susceptible to higher default rates and credit risks within its non-QM portfolio.
The company just went through a 1-to-4 reverse stock split, which the market doesn't usually see as an encouraging sign. Beyond that, I wouldn't expect its dividend to hold up for long given recent precedent. The company's dividend payouts have declined by 27% over the past five years, so a cut in the near future if conditions don't improve quickly wouldn't be a shock. If you're looking for safety in your yield, there are other high-yield dividend stocks that offer far more security and growth opportunities.