Annaly Capital Management (NYSE: NLY) offers investors a tempting dividend yield. At more than 13%, it’s 10 times higher than the S&P 500‘s dividend yield.
With that higher yield comes more risk. The mortgage real estate investment trust (REIT) uses lots of leverage to invest in mortgage-backed securities (MBS) backed by government agencies like Fannie Mae. While that leverage can boost its returns, it also enhances its volatility. That latter issue has caused the REIT to cut its dividend in the past. However, it successfully navigated more challenging market conditions in the second quarter, which should ease concerns about another dividend cut for now.
Thriving in the face of challenges
Annaly Capital Management generated $0.68 per share of earnings available for distribution (EAD) in the second quarter. That was enough to cover its current dividend payment of $0.65 per share. It was also an improvement from the first quarter, when EAD fell to $0.64 per share, putting it below the dividend level.
The REIT’s improved EAD was impressive, considering the challenges it faced in the quarter. CEO David Finkelstein stated on the second-quarter conference call that the company “saw a fair amount of volatility” in the period. He noted that interest rates rose modestly in the quarter as economic data in April caused the market to temper its rate cut expectations this year. As a result, Agency MBS spreads widened during this period.
Despite this challenging environment, Annaly delivered a roughly 1% economic return in the quarter and 5.7% through the first half of the year. That performance “demonstrate[ed] the strength of our housing finance model,” commented the CEO in the earnings press release. It delivered those solid earnings and returns while maintaining a prudent leverage ratio of 5.8 times. That strong financial position enabled the company to opportunistically add to its Agency MBS portfolio in the quarter to capitalize on the attractive spread levels.
Better days could lie ahead
While the second quarter was more challenging, Annaly sees signs that market conditions could improve in the coming quarters. Finkelstein noted on the second-quarter call that economic activity has gradually slowed as high interest rates begin affecting more parts of the economy. Further, while inflation remains elevated, recent data showed shelter-related inflation is “finally starting to soften.” Add in a more balanced labor market, and there’s a growing belief that a near-term rate cut by the Federal Reserve is increasingly likely.
Moderating interest rate volatility and a more accommodative monetary policy by the Fed would benefit Annally. Finkelstein noted on the call that “this should steepen the yield curve, reduce volatility, and ultimately, in our view, lead to agency outperformance.”
The company believes its current capital allocation and portfolio construction position it “to generate sustainable returns in an environment that should be favorable to fixed-income investors,” stated the CEO. On top of that, the REIT has lots of liquidity, which will enable it to grow its portfolio opportunistically.
That outlook bodes well for the company’s ability to maintain its big-time dividend. Payout sustainability has been a problem for Annaly in the past. It cut its payout by 26.1% in early 2023 due to an expected decline in its EAD, which is what occurred. It also reduced its dividend in 2020 and 2019.
Annaly’s dividend seems safe for now. However, the company’s history of cuts and the potential for renewed volatility in the future mean that investors might not be able to bank on it sustaining its dividend forever.
A solid showing
Annaly Capital Management delivered solid second-quarter results, especially in light of the challenging market conditions. Because of that and its growing optimism for what’s ahead, the company’s big-time dividend seems safe for now. However, with a history of dividend cuts (and a high payout ratio), it’s not the most bankable dividend. Given its risks, income-seeking investors might want to look elsewhere for a more sustainable income stream.
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Matt DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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