The Safety Net: Is This 20% Yield Safe?

Marc Lichtenfeld By Marc Lichtenfeld, Chief Income Strategist, The Oxford Club

Dividend Investing

When a reader asks me to take a look at the dividend safety of a stock with a 20% yield, I pretty much know what rating it’s going to get even before I dive into the numbers.

So it’s no surprise that I expect Western Asset Mortgage Capital Corp. (NYSE: WMC) to cut its dividend. Even in the world of mortgage REITs, which have significantly higher yields than your average stock, 20% is extreme.

In fact, Western Asset Mortgage just cut its quarterly dividend from $0.95 to $0.90 two weeks ago. Now, most of you probably won’t shed too many tears for the investor who is still getting a 20% yield, even at $0.90 per share – but since The Safety Net is all about dividend safety, let’s take a closer look at the stock.

Mortgage REITs have taken a thumping in the past couple of months as interest rates have gone higher.

As long as short-term rates stay the same, this should be a good opportunity for mREITs to grow profits as they borrow at short-term rates and lend/invest at long-term rates.

However, the spike in interest rates decreases the value of their assets on hand, which has reduced the stock prices. The second quarter earnings results may be particularly tough for the sector.

In the first quarter, Western Asset Mortgage lost $29 million, but generated $52 million in cash flow from operations due primarily to unrealized loss on residential mortgage-backed securities and other securities.
In other words, the company had to show those losses as an expense on its income statement, which resulted in a net loss. But Western Asset Mortgage didn’t actually close out those positions to take the loss. It’s only a loss on the books, so it did not impact the amount of cash generated during the quarter.

During the quarter it paid out $27 million in dividends. With $52 million in cash flow from operating activities, that’s more than enough to cover the dividend.

From May 15, 2012, through the end of the year (the company only came public in May) Western Asset Mortgage also generated enough cash flow from operations to cover the dividend. That’s a good sign.

What’s not a good sign is the deterioration of book value, its short track record, the fact that it already cut the dividend and a dividend yield that is extreme.

If the mREIT business were honky-dory these days, I’d give Western Asset Mortgage some slack. But because the second quarter is likely to be difficult for mREITs and Western Asset Mortgage in particular, I don’t believe its current $0.90 per share quarterly dividend is sustainable.

Dividend Safety Rating: D

Keep in mind that mREITs’ dividends tend to be volatile. They can be up big one quarter and down the next. They typically don’t steadily and surely rise like a regular dividend-paying stock with a 4% yield, for example.

So any mREIT, regardless of the interest rate environment, probably won’t get a great dividend safety rating. It doesn’t mean they’re bad investments or that an investor won’t collect a significant yield. It just means the dividend could be volatile.

When I rate the companies’ dividend safety, I’m comparing them to each other. Some stocks such as Genuine Parts (NYSE: GPC) have raised the dividend every year for over 50 years. A dividend like that is likely very safe.

If you have a stock whose dividend safety you’d like me to check out, please leave the ticker symbol in the comments section below.