Often enough, a stock sporting a high dividend yield is a red flag that the company may be in trouble. It’s an indication that investors are beginning to suspect the dividend is going to be cut, especially if the stock’s yield is an outlier compared to other companies in the same business sector.

That said, there are some types of stocks that do pay a high yield because of the nature of their business, and it is not a red flag. Real estate investment trusts (REITs) routinely have high dividend yields, and Annaly Capital Management (NYSE:NLY) is one such stock with a yield that appears high but is actually quite safe and manageable.

A source of high yields

REITs generally have higher than normal yields because they are required to distribute the majority of their earnings via dividends in order to maintain their exemption from corporate taxes. Real estate investment trusts generally follow a landlord/tenant model, where the REIT develops a rental income-producing property such as an office building, apartment complex, or shopping mall.

Annaly Capital is a mortgage REIT, which is different than the typical REIT. Mortgage REITs don’t invest in real property; they invest in real estate debt. And Annaly is an agency REIT, which means it focuses on mortgages that are guaranteed by the federal government. This means that the company takes limited credit risk, but it has more interest rate exposure, so it must control its interest rate exposure tightly. In many ways, mortgage REITs resemble a bank more than the typical REIT.

Annaly purchases mortgage-backed securities that have yields around 3% to 4% and then uses leverage (in other words, borrowed money) to turn the portfolio into something that supports a near-10% dividend yield. The mortgage REIT is doing what an individual investor does when using margin. Say you want to invest $1,000 in a stock. You can use margin to buy $2,000 worth of stock. A mortgage REIT is more likely to invest $1,000 and use leverage to buy $7,000 worth of mortgage-backed securities. That use of leverage can become a risk when the securities markets have bouts of illiquidity. We saw that happen last year during the early days of the pandemic. Just about every mortgage REIT was forced to cut its dividend, but Annaly cut its payout by the least.

Annaly is adding its exposure to credit

Annaly operates three… Continue reading at The Motley Fool