By Aristofanis Papadatos
In the last three months, Annaly Capital Management (NLY) has outperformed the market.
During this period, the stock has remained essentially flat whereas the S&P has lost 15%. As most of the shareholders of this high-yield stock are holding it for its exceptionally generous 12.0% dividend, the big question is: How safe is the dividend?
Annaly is a leading diversified capital manager that is focused on investing and financing of residential and commercial assets. It borrows funds from the repo market and invests in agency mortgage-backed securities. As a result, it profits from the spread between the long-term interest rates of its investments and its short-term borrowing rate.
Annaly has greatly enhanced the diversification of its investments in the last five years. During this period, it has almost tripled the number of available investing options and has thus stabilized its performance.
This strategic shift is clearly reflected in the consistency of its dividend payments. Until five years ago, the quarterly dividend of Annaly was extremely volatile and highly unpredictable. However, thanks to its diversified strategy, the company has managed to declare a quarterly dividend of $0.30 per share for 20 consecutive quarters.
This consistency is paramount for investors, particularly given that the vast majority of the shareholders of Annaly are likely holding the stock for its generous dividend.
During the first 9 months of fiscal 2018 Annaly has posted adjusted earnings-per-share of $0.85. The company pays out a dividend of $0.30 per share.
The company's payout ratio has exceeded 100% through the first 3 quarters of fiscal 2018. This is a clear sign of risk. There is no margin of safety for Annaly's dividend. In fact, the company must earn slightly more going forward to cover its current dividend.
The greatest risk for Annaly has always been an unexpected steep move in interest rates. This risk had almost disappeared from the horizon in the last decade, as the Fed was doing its best to avoid surprising the investing community.
However, the Fed changed its stance in its latest meeting and chose to raise interest rates once again even though the market was expecting a pause in interest rate hikes. Nevertheless, as this move of the Fed caused a meltdown of the markets, we do not expect similar surprises going forward. In addition, interest rates have risen at a fast pace in the last two years so it will not hurt the Fed to become somewhat more patient in its next hikes.
Another risk is the possibility of an upcoming recession. As the Fed has been raising interest rates aggressively, it may cause a recession within the next one or two years. This is the exact reason that the financial markets collapsed after its latest rate hike. As a recession has not shown up for nine consecutive years, investors should be prepared for such an event, particularly amid rising interest rates.
Nevertheless, in the Great Recession, the worst financial crisis of the last 80 years, Annaly did not cut its dividend. Instead it continued to raise its dividend throughout the recession. While the business model of Annaly is complicated, its resilience throughout the fierce recession can be explained by the plunge of short-term interest rates that occurs during recessions. This plunge reduces the borrowing cost of the company at a much faster pace than it reduces the return of its investments, as long-term rates fall much more slowly than short-term rates.
While Annaly did not reduce its dividend during The Great Recession, its dividend did fall from a high of $2.65 in 2010 down to $1.14 in 2014. It has remained at $1.20 per year since 2015.
One point of concern is the high leverage that Annaly uses in its portfolio in order to achieve its high yield. Annaly increased its leverage from 6.4 in the second quarter of this year to 6.7 in the third quarter. While the use of leverage has greatly benefited its shareholders over the last decade, there is no free lunch in the market. The high leverage exposes the company to increased risk when the underlying economic conditions change unexpectedly in such a way that they force the company to deleverage.
Annaly is offering a 12.0% dividend yield. Investors should always remember that such a high yield is never without risks.
The biggest red flag surrounding Annaly's dividend is its high payout ratio. The company is not guaranteed to cut its dividend, but there is elevated risk here.
If the company were to have any downturn in its operations from this point, a dividend cut would be warranted. Investors in Annaly should take caution that the dividend could be reduced in the future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.