I review a lot of high-yield investments. You likely are aware that an investment gets priced for a higher-than-typical yield because of the potential or possibility of a dividend rate reduction. The interesting part about a company’s decision to change its dividend is that it is a binary event. Either the dividend is cut, or it will be sustained. The goal as an investor is to find and invest in high-yield stocks that don’t cut the dividends. Dividend reductions are the landmines of income-focused investing statagies.
The pandemic triggered an economic shutdown, and related
financial markets crash, has already pushed hundreds
of companies with high-yield stocks into dividend cuts. Because share
prices are so low, many of these stocks still have very high percentage yields.
You may think it’s safe to get back into the stocks with
already-cut dividends. However, for certain types of high-yield businesses, it’s
a case of once a landmine dividend stock, always a landmine dividend stock.
Dividend cuts are independent of the company’s stock price
and the current yield. Just because a stock has dropped a lot—and the yield is
now very high—does not automatically mean the company will cut the dividend
rate.
The ability to pay dividends depends on business results and
the amount of free cash flow generated by the business. The corporate board of directors
determines whether the dividend will be sustained or reduced based on business
results and the business future outlook.
Here are some types of businesses that are always dividend
cut landmines. And one that, post-pandemic, has the potential to surprise
investors with more dividend reductions.
Agency mortgage-backed securities real estate investment
trusts (MBS REITs) are companies that own highly leveraged portfolios of U.S.
government agency guaranteed mortgage-backed securities. These companies are
classified as finance REITs. Not all finance REITs are dividend landmines. You
need to look for the code words “agency MBS” and the fact the companies
leverage up their equity to six times or more. Here are two popular high-yield
finance REITs to avoid.
Annaly Capital Management (NLY) currently yields
14.75%.
This is a stock I get a lot of questions about from my Dividend
Hunter readers.
To get the cash flow to pay the big yield, the company
reported economic leverage of 6.8 times for the 2020 first quarter. For that
quarter, Annaly paid a $0.25 dividend.
Unfortunately, core earnings were just $0.21 per share. In
2012, the Annaly dividend was $0.55 per share. In 2019, it was cut from $0.30
per share down to the current $0.25 per share. Over the past six years—but before
the recent crash—the share price dropped by 41%.
Annaly is a dividend landmine with a reset button.
AGNC Investment Corp. (AGNC) is another agency MBS
REIT. It currently yields 11.4%.
For the first quarter, AGNC reported 9.4 times “tangible net
book value ‘at-risk’ leverage.” That phrase alone shows how complicated the
business model is.
The company reported $0.57 per share in net spread income,
against $0.48 paid in dividends. That’s a good thing. The bad thing is, the
leveraged agency MBS business model always stops generating enough cash eventually.
The AGNC dividend has been cut four times in the last five
years, pulling the share price down with the reductions.
Shipping stocks are another high-yield investing landmine.
Ship leasing rates are very volatile, fluctuating wildly with swings in the
global economy. When rates are high, the shippers lock in those rates with
multi-year contracts, and they pay out big dividends. When the leases expire,
renewal lease rates are often much lower, and the dividends get slashed.
Frontline Ltd. (FRO) owns a fleet of 70 crude oil
tankers used for floating oil storage.
With crude oil demand destruction, tanker rates have
skyrocketed. Frontline, which paid a $0.10 per share dividend in December, and
a $0.40 per share dividend in March, has declared a $0.70 dividend payable in
June. The current yield based on the latest dividend is over 30%.
Investors may get a few more big dividends from Frontline,
but eventually tanker lease rates will come back down—and so will the dividend.
Golar LNG Partners (GMLP) owns and operates a fleet
of LNG carriers and LNG floating and storage regasification units (FSRUs).
The vessels are on long-term contracts, and before the
pandemic, Golar paid out almost 100% of free cash flow as a $0.4042 per share
dividend.
The yield on Golar before the market crash was 17% to 18%.
When the so-called “coronacrisis” took down the energy sector, the Golar
management took the opportunity to slash the dividend to $0.02 per share and renegotiate
terms with its bondholders.
Common shareholders were left holding the bag.
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