Ep. 107: The Distribution Rate Is the Easy Part — What Actually Backs the Yield

You know, when you see like a vintage muscle car gleaming on the dealership
lot, the very first thing that grabs your attention is the paint job.
Oh, definitely.
It's shiny.
It's yeah, it just screams power, right?
You look at it and your immediate instinct is, well, I want that.
But the paint job doesn't actually get you down the highway.
I mean, it just looks incredibly good sitting there.
Exactly.
Eventually you have to pop the hood and sometimes you pop the hood on that
beautiful, aggressive looking car and you find a struggling duct taped lawnmower
engine trying to run the whole operation.
It is a very shiny disappointment.
Yeah.
And that is a painfully accurate way to look at the world of income investing
right now.
I mean, we are entirely surrounded by these shiny, double digit dividend
yields that just absolutely incredible on the surface.
I think it was amazing.
Right.
But in a world of constant information overload, critical thinking is the only
thing that saves your portfolio.
When a payout looks too good to be true, you can't just admire the paint.
You really have to look at the engine.
That shiny disappointment is exactly what's happening across the market today.
So welcome to the deep dive today.
Our mission is to pop the hood on those massive yields for you.
We really want to get into the mechanics.
We are.
We're going to cut through the noise to figure out a single critical through line.
The headline distribution rate is the easy part.
What actually backs that yield is the hard part.
Okay, let's unpack this.
Yeah, let's get into it.
Because by the end of our time together, you'll be able to look past a flashy
dividend percentage and understand the underlying mechanics.
We want you to know immediately, you know, is it real cash flow?
Is it downside protection?
Or is it just a risky erosion of your own principle to really understand how
a dividend is funded?
It's best to start at the micro level, I think.
Before we dive into complex engineered funds, we really need to look
at a familiar individual business, right?
Just to see how cash flow operates in the real world.
Exactly.
You have to see the engine in its most basic form.
So let's start with an absolute staple of the grocery aisle.
General mills take the symbol GIS.
Right now it's trading at $37.97.
And it is throwing off a massive 6.43% trailing yield, which is huge for them.
Yeah, that is its highest yield in a full decade.
So if you just look at that percentage, it feels like a massive win for income
investors.
It definitely feels like one.
But what's fascinating here is what happens when we look at the most critical
metric for any dividend payer, which is free cash flow coverage.
Okay.
So the actual cash leftover, right?
The hard cash leftover after the company pays its operating expenses and its
capital expenditures.
So in fiscal year 2026, general mills generated $1.63 billion in free cash flow
against $1.32 billion in dividend payments.
So just doing the math there, they brought in more actual cash than they paid
out to shareholders precisely.
That gives them a coverage ratio of 1.24x.
And you know, anything above 1.0x means the payout is funded by real cash flow
not by taking on debt to pay investors.
Sounds great.
It does.
But however, the safety rests on a very specific temporary detail.
They had below normal capital expenditures or cap X for the year.
And cap X is the money they spend to maintain factories, buy new delivery
trucks, just keep the physical business running.
Right.
I mean, you can't just stop maintaining your ovens if you're making Cheerios.
Exactly.
So if you normalize their cap X, meaning, you know, if you adjust the math to
reflect what they historically have to spend over a regular timeline to keep
equipment running, that free cash flow shrinks.
And suddenly that coverage ratio drops to a much thinner 1.15x.
Wait, this is exactly like a household budget.
If I make $1,600 a month and I spend 1,300 on my bills, I'm technically
covered today.
Yeah, you're fine for the month.
My coverage ratio is positive.
I can breathe easy.
But what if my salary is actively shrinking every single year?
When you look at the raw financial data, there are some serious structural
headwinds for general mills.
There really are.
Their revenue has declined for three consecutive years, dropping from 20.09
billion down to 18.42 billion.
Plus they are carrying a 3.9x net debt to ebit
leverage, which is, well, it's a significant debt load.
And then it is, that is the lawnmower engine under the hood.
The 6.43% yield is entirely genuine today.
I mean, it is currently covered by cash, right?
They aren't faking the cash today.
Exactly.
Management also has a $3 billion cost savings initiative in play that might help
defend their profit margins in the short term.
But here is the reality of the business world.
Cutting costs doesn't fix a shrinking volume of cereal and snacks actually
being sold to consumers.
Yeah, you can only cut so much.
Right.
The long term sustainability of that dividend hinges entirely on them
resolving that top line business shrinkage.
So if picking an individual stock like general mills leaves you exposed to the
very specific risk of a single shrinking cereal empire, you naturally start
looking for a basket.
Like, how do we find stability through diversification instead?
Well, that brings us to a fundamentally different approach.
The pro shares, S&P 500 dividend aristocrats ETF ticker, no, no, no,
BL, this fund doesn't chase the absolute highest yield.
Instead, it's built around a very specific defensive superpower.
A massive superpower, honestly.
Look at what happened during the brutal 2022 bear market.
No, no, BL fell only 6.5%.
Yeah, it held up incredibly well.
Meanwhile, the broader S&P 500 plummeted roughly 18%.
Give it and focused investors holding this fund took about two thirds less
of the decline.
That is incredible defense.
How mechanically are they pulling that off?
It really comes down to their incredibly strict inclusion rules.
No, BL only targets companies with 25 or more years of consecutive dividend growth.
Wow, 25 years.
Right.
Think about what it takes for business to raise its dividend every single year
through recessions, tech bubbles, global crises.
By definition, these are mature, heavily entrenched businesses.
And sell things people actually need.
Exactly.
They sell products and services that consumers absolutely have to buy,
regardless of what the broader economy is doing.
So we're talking about sectors that simply don't care if interest rates are upper
down precisely.
The sector mix is aggressively defensive.
You have consumer staples, industrials, financials, materials and healthcare all
sitting around 10% or more of the fund each.
Okay, so very balanced.
Yeah.
And technology, which drives so much of the S&P 500's volatility and wild swings,
makes up only 3% of no BL.
The top holdings are companies like West Pharmaceutical Services, ADP and
ABV, tickers, WST, ADP and ABBV, companies doing payroll processing and
essential healthcare.
Here's where it gets really interesting, though.
By keeping tech at only 3%, are we essentially buying that bear market
insurance by putting a permanent speed limit on our money?
That's a great point.
Because if you have almost no exposure to Silicon Valley, you are going to get
absolutely left in the dust when the market goes on a massive bull run.
You are entirely correct to point that out.
That is the explicit mathematical trade off of this strategy.
Over a 10-year timeline, an OBL returned about 10% per year.
By comparison, the Vanguard S&P 500 ETF ticker VOO returned about 15% per year.
That's a big gap over a decade.
It is.
And OBL has a 10-year beta of 0.83, meaning if the overall market swings a full
dollar, you'd only only swing 83 cents.
Exactly.
It is structurally less volatile.
You are explicitly sacrificing bull market growth in exchange for bear
market stability.
It is a calculated deliberate choice for an investor with a lower risk tolerance.
It's not a flaw in the funds design.
It is the entire point of the funds design.
Okay.
So no BL represents the conservative low yield, sleep well at night, end of the
spectrum.
You can set 10% returns to avoid the gut wrenching drops.
Yep.
You sleep easy.
But a 10% total return doesn't satisfy everyone.
When investors get hungry for more cash today, they start climbing.
What's known in the industry is the dividend risk ladder and things get very
complicated, very fast.
They certainly do.
The dividend risk ladder is a brilliant mental model, I think, because it helps us
categorize this pursuit of yield into three distinct tiers of danger.
Let's climb it.
So tier one is the core.
These are your foundational holdings, things like AT&T, ticker T and real T income ticker
O. These are giving you dependable income without excessive
volatility, usually yielding somewhere in the five to eight percent range.
Right.
Very standard foundational stuff.
And I know real T income is absolutely beloved in the income investing
community, because it pays out its dividend monthly.
If you are trying to match your investment cash flow to your actual
monthly living expenses like rent or groceries, that consistent monthly
check is gold.
It really is, but eventually investors look for a raise and they step up to tier
two, which is high yield.
Here we are looking at mortgage reads or real estate investment trusts like
annually capital, ticker NLY and AGNC investment ticker AGNC.
These can yield anywhere from 10 to 15%, which is a massive jump from five percent.
How are they doing that?
Well, if we connect this to the bigger picture, these funds are operating in a totally
different macroeconomic reality.
A mortgage read doesn't own physical apartment buildings.
They buy mortgages.
Okay.
So it's all paper, right?
They borrow money at short term rates and buy long term mortgages that pay a higher
rate, profiting from the spread between the two.
Because they use a lot of leverage to do this, they're incredibly sensitive to
interest rate changes.
Ah, so when rates move, they feel it immediately.
Exactly.
If the yield curve inverts or borrowing costs spike, their profit margins get
crushed.
They carry severe, semper specific risk, and there is a very real historical
precedent of them slashing their dividends during economic downturns, which
brings us to the very top of the ladder, tier three, maximum risk.
Looking at the data on this tier, the numbers look like absolute typos.
We were talking about yield max covered call funds.
Yeah, the numbers get pretty wild here.
You have YGMA and the NVIDIA based fund NVDY paying around 54 percent.
And then there's MSTY, the micro strategy fund yielding an absolutely absurd
175 percent.
I assure you it is not a typo, but capturing 175 percent yield requires a deep
understanding of the underlying mechanics.
These funds generate those massive payouts by selling covered calls on highly
volatile underlying stocks.
OK, let's unpack a covered call really quick.
Essentially, you own the underlying stock, but you sell a contract to someone
else, giving them the right to buy your stock at a specific higher price later on.
Right.
And they pay you a premium for that.
They pay you cash right now for that privilege.
And that cash is the yield spot on.
But wait, that means your upside growth is explicitly capped by the contract
you just sold.
If the underlying stock shoots up 30 percent in a month, you don't
get all of that gain because you promise to sell it at that capped price.
That's the trade off.
But if the underlying stock tanks, the fund doesn't have any downside protection.
So you take 100 percent of the losses.
That sounds like picking up pennies in front of a steamroller.
That is precisely the mechanical reality.
The headline distribution rate that 54 percent or 175 percent completely
masks your total exposure to principled decline.
It's just hiding the risk.
Yeah.
If the underlying asset drops, the value of your shares drops right along with it
and your initial capital is eroded, you are trading all of your upside
potential for immediate cash while keeping all of the downside risk.
Those ultra high yields require extreme caution.
But wait, if those covered call funds cap your upside and leave you fully exposed
to the downside, what happens when a fund promises double digit yields on an
asset that's actively crashing because that is the ultimate paradox.
Like how can a double digit yield even coexist with a crashing share price in
the real world?
We can see this exact mechanic play out vividly with BTCI.
This is an actively managed Bitcoin income ETF.
It explicitly targets a 26 to 30 percent monthly distribution rate.
And with wild is that it maintained that double digit target distribution rate
even during a major downturn with the price of Bitcoin took an absolute
bath. Right.
During a total crash.
How is that mechanically possible to keep paying out when the asset is dropping?
We have to open up the hood of the fund because of the investment company
act of 1940, these types of funds have strict regulatory limits.
DTCI can only hold 25 percent of its assets in actual spot Bitcoin,
utilizing ETFs like IBIT or HODL.
But to track Bitcoin properly, they want to give investors a 100 percent
exposure to its price movements.
Exactly.
So to get that remaining 75 percent of notional exposure without violating
the 40 act, they use what are called synthetic longs, which are backed by US
T bills. Okay, explain this synthetic long for us.
A synthetic long is an option strategy.
The fund buys a call option, giving them the right to buy Bitcoin if it goes up.
And they simultaneously sell a put option at the exact same strike price,
forcing them to buy it if it goes down.
Oh, I see.
Yeah, when you combine buying a call and selling a put it perfectly mimics the
financial experience of just owning the asset outright.
Therefore, if the price of Bitcoin drops, the funds net asset value or
NAV drops one to one with it.
So what does this actually mean for my wallet?
If the share price erodes because Bitcoin is down, my 26% yield is just
26% of a shrinking pie.
The math. Yeah.
The percentage target stays exactly the same on paper.
But my actual physical dollar income going into my checking account goes down.
That is entirely true and is a vital distinction.
The percentage distribution stays constant.
But the actual dollar payout fluctuates with the market price.
If your pie shrinks, 26% of that pie is fewer calories.
However, there is a very nuanced upside here that active portfolio managers
heavily utilize an upside to NA erosion.
That sounds contradictory.
It's all about how the money is taxed by the IRS.
Because of how these specific options contracts are structured,
the distributions from a fund like BTCI are largely classified as a return of
capital or ROC.
Okay, return to capital, meaning they're essentially just giving you your own
original money back.
Structurally, yes, but practically this acts as a massive tax deferral.
Let's do the math.
Think of it this way.
If you buy a share of a fund for $100 and they pay you $10 categorized as
return of capital, you don't pay any income tax on that $10 today.
Yeah, the IRS basically says, okay, they just gave you your own money back.
So we will lower your official purchase price.
Your cost basis is now $90.
You only pay taxes on that $10 difference when you eventually sell the shares
down the road.
And hopefully at that point, you've held them longer than a year.
Right.
So it's taxed at the much lower long term capital gains rate,
rather than your ordinary income tax rate.
For an active investor managing their tax burden and a taxable brokerage
account, that deferral is a massive strategic benefit,
even while navigating the NAV erosion.
Okay, we have traversed an incredibly chaotic landscape today.
We've gone from the cash flow mechanics of Cheerios and General Mills
to the bear market armor of no BL up the terrifying runs of the yield max
risk ladder and straight into the synthetic options math of Bitcoin ETFs.
Let's build a practical filtering system.
How do you actually filter all this noise into a coherent strategy?
Let's lay out a sober five step framework for picking income ETFs.
This is designed specifically to keep you out of trouble and keep your engine running.
Step one, look for a clear one five and 10 year upward trend in the chart.
You want momentum firmly on your side, proving the strategy works across different
market cycles.
Makes sense.
Step two, aim for a realistic average annual performance of around seven percent.
We are not looking for tech level 20% growth here.
We want sustainable compounding.
Right.
Keep your expectations grounded in reality.
Step three, ensure the expense ratio is below 0.50%.
High management fees will quietly eat your compounding returns alive over a 20 year period.
Step four, target a realistic dividend yield between two and four percent.
So if you see a fund shouting about 175% yield, run the other way.
Exactly.
And finally, step five, ensure the fund strictly avoids penny stocks or mean stocks.
The underlying holdings should mirror established mature companies like those found in the
Dow 30 or the S&P 500.
I love how actionable that framework is.
And what's really fascinating is looking at how this plays out when tested with real
capital and investor decided to build a defensive moat in their portfolio.
So they ran a test on five non tech sector income ETFs from state street.
Testing the theory in the real world changes everything.
What did the data actually show?
The results were ruthless, but logical.
They completely dumped the industrial materials and healthcare sector funds.
Interesting.
Why?
Because they just lacked price momentum.
But they kept three specific sectors and actually tripled down on them to build their
income engine, which three sectors passed the test.
First was XLEI, the energy sector fund.
Now, even though the price of the fund was actually down 3%, they kept it why?
Because it yields a massive 20% and historically, energy acts as a fantastic
portfolio shock absorber.
Oh, definitely.
When the tech sector takes a breather or inflation spikes, energy usually holds up.
That makes perfect sense.
It behaves fundamentally differently than Silicon Valley.
Exactly.
It's a non correlated asset.
Next was XLUI, the utility sector.
They held this for pure defensive stability lights, water, heat.
These are things people absolutely must pay for even in a deep recession.
You don't cancel your water bill when the stock market drops.
Exactly.
And finally, XLSI consumer staples.
It's yielding around 10 to 11%.
It's an incredibly boring, predictable revenue.
People still buy toothpaste and diet soda, no matter what the Federal Reserve is doing.
It's a very disciplined approach to isolating your cash flow.
It really is.
It's exactly like owning a rental property.
When you own a rental house, you don't log on to Zillow every single morning to stress
over whether the algorithm says your house's value fluctuated by a $1,000 overnight.
No, you drive yourself crazy.
You don't care.
You only care that the monthly rent check clears the bank so you can pay your bills.
You judge the asset on its income generation, not its daily price ticker.
I completely agree with that mindset.
It totally isolates your cash flow and your psychological state from the daily
mood swings of big tech in the broader stock market.
You are building an income engine that runs independently of whatever the market
sentiment happens to be on any given Tuesday.
So let's bring it all together.
We started by popping the hood on general mills to see if their 1.24x cash flow
coverage was enough to offset three years of shrinking revenues.
We looked at no BL explicitly accepting a 10% speed limit on growth to ensure they
only dropped 6.5% when the market was bleeding in 2022.
We climbed the dividend risk ladder observing the very real mathematical
danger of capped upside and uncapped downside in those ultra high yield covered
call funds.
We dissected how BTCI maintains a double digit distribution,
even while Bitcoin falls through synthetic logs and why that return a capital tax
deferral matter so much active managers.
And finally, we granted it all with a practical five step framework and the rental
property mindset of sector income investing.
This raises an important question.
Looking across all these different financial mechanisms,
what stands out to you in your own portfolio?
Are you fully aware of how your yield is actually being generated?
That is the perfect question because once you've built your income engine and
those rent checks are clearing, you might think you're done.
But here's something new to mull over as you review your accounts this week.
When the macro economic weather eventually changes and interest rates drop,
making the cost of capital cheap again,
how many of these safe defensive sectors are suddenly going to look like dead
weight compared to fixed income bonds?
That's a scary thought.
It really is.
Are you prepared to rebuild the engine with a macro economic weather changes?
Or are you just coasting on today's shiny yield?
The engine is always more important than the paint job unbelievably true.
Thank you for joining us on this deep dive.
Keep popping the hood on your own portfolio.
Keep asking the hard questions and we will catch you next time.