Annaly Capital Management (NLY: $9.60, down 1% today) paid shareholders $0.30 per share every quarter going back to 2013. That's the company we've recommended all these years. Now that management has cut back to $0.25, it's time to review.
First, we have to appreciate the honesty even if the lower quarterly payout is a shock. The people who've been running Annaly for years took a hard look at the credit environment and made a conscious choice not to take on more risk in order to chase higher returns. They'd rather stick with a strategy that can reliably generate $0.25 per quarter than stretch for $0.05 that may or may not actually happen. Here's how they put it:
"Although we could maintain elevated earnings and dividend payouts by increasing leverage, we are focused on optimal liquidity thresholds in managing the portfolio within conservative risk parameters to produce the highest level of quality earnings in this market environment."
It's their choice. They want to make sure they're here for the long haul and that at the end of the day the balance sheet doesn't stretch past the point of no return. By their standards, there's a lot of room to stretch. In theory, they could take on as much as 12X leverage (debt divided by equity, in their definition) under the right conditions. For years, they've kept debt around half that level.
This doesn't mean this is a risk-free proposition. The company still owes 6.2X as much as it has equity and with under $1.6 billion in cash there isn't a lot of liquidity to anchor what's still $97 billion in debt, in a credit market meltdown. Sure, there's $110 billion in the investment portfolio, but the dangerous thing about leverage is that by the time it turns against you, it's usually too late to sell down the assets in order to pay the bills. That's the situation management wants to avoid.
Do they see a credit market meltdown in the wings? We don't think so. Instead, the tone on the conference call was more about discipline. The Annaly team is actually fairly confident that they could squeeze that extra $0.05 per share out of what they admit is an abnormally flat interest rate curve. (Remember, the company makes money borrowing cheap to buy higher-yielding instruments. As the spread between the borrow and the buy narrows, money gets harder to make.) They just don't want to subject shareholders to the added risk that this would entail.
They're not happy about it. They were proud of maintaining that $0.30 dividend for years, but you just can't fight the yield curve. We believe that when the curve steepens again, they'll give us back our $0.05.
What this means for us is equally pragmatic. When we first found Annaly in 2016, it was a $9.90 stock that paid $1.20 per year for a 12.1% yield. Subscribers who locked in that yield have earned $3.90 per share on that $9.90 over the last three years while the stock effectively went nowhere. From here, $0.25 for the foreseeable future translates into a 10.0% yield on that $9.90 cost basis, which is a whole lot better than just about anything else even though it's a 2% letdown for people who got comfortable with 12%.
For us, giving up the 2% is hard but realistic. If we were offered the chance to recommend Annaly at a 10% yield, we'd take it. It may not be as big a cash generator as it was three years ago, but it's still running rings around Treasury yields and most forms of "junk" debt. The S&P 500 pays 1.8% a year in dividends. Utilities are trending around 3%. The world has gotten a little more challenging while the yield curve untangles, but this is still one of the brightest income opportunities on our screen. And now management has confirmed that their eyes are wide open. They aren't on autopilot. They're convinced they can give us 10% a year in the flattest rate environment of their careers.
That clarity is worth something. We might pull the plug on Annaly sometime, but not yet.