The decades-high inflation we're seeing today, coupled with a slowing economy, has resulted in the average stock losing nearly a fifth of its capitalization over the last 12 months.
Many investors, subsequently, try to offset their losses by turning to high-yield dividend stocks. The mortgage real estate investment trust (mREIT) Annaly Capital Management (NLY 0.81%) is one of the highest-yielding stocks in the market today, paying a juicy 16% dividend yield.
A double-digit yield is attractive, but there are several risks for investors to consider before buying, including a potential dividend cut in the coming year.
Pressures on mortgage REITs aren't subsiding
Annaly Capital Management invests in mortgages and mortgage-backed securities (MBS) in addition to servicing loans for other mortgage companies. Its portfolio is largely made up of government-backed loans (things like USDA, FHA, or VA loans), but it also includes jumbo loans or mortgages on rental properties.
The mortgage boom of 2020 and 2021 was fantastic for the mortgage industry. Loan originations and home refinancing reached record levels thanks to super-low interest rates. Origination demand doesn't directly affect a company like Annaly, which purchases existing loans on the secondary market. But the low cost of borrowing did help it achieve a higher net interest margin, which is how it makes its money. Annaly earns its revenue from collecting interest on a loan on top of the spread it makes between its cost of acquisition and what's collected on the loan.
Now that interest rates are rising, how much Annaly is earning is dwindling. The company's net interest margin has fallen by 100 basis points since last quarter to 1.42%. But such a wafer-thin margin is hardly sufficient to sustain a 16% dividend yield, which means the company would eventually have to borrow money to continue growing its portfolio as well as revenue. Considering that interest rates are expected to rise even further as the Federal Reserve tries to tame inflation, the mREIT's margins could get thinner.
On top of that, the government has also stopped its MBS purchases this year, eliminating a major buyer for Annaly's assets. Treasury yields have also surpassed MBS yields, reducing MBS demand in the secondary markets. This hurts mREITs' book values, which are closely tied to share price values. In the third quarter of 2022, Annaly's book value fell 15% from the quarter prior, while its share price dropped by 27%.
Rising interest rates, credit risk from borrowers' defaulting, and weakening demand for the assets Annaly buys and sells are all pressures that are being carried into the new year. And given that the company is now operating at a net loss, a dividend cut in 2023 is likely.
Annaly has a history of dividend cuts
Annaly Capital Management has a long history of dividend cuts. Since 2008, the company has cut its dividend 15 times, equating to roughly a 56% decrease in payouts. The most recent cut was in 2020 following the onset of the pandemic.
There's a good chance that even with a dividend cut, the company will still pay an attractive double-digit yield. Annaly has managed to keep its dividend yield above 7% or more for the past 10 years because its share price has fallen during that same period. Since yield and share value have an inverse relationship, it's been able to maintain attractive dividend yields despite losing value for its shareholders.
I believe the risk/reward calculation for a high-yield company like Annaly Capital Management simply isn't worth it. The economy isn't favoring an investment in the stock today despite its low price and high yield. Investors looking for a strong return to help offset inflation or portfolio losses have other, more-reliable options that will likely pay off far better over the long term than Annaly.
