Ep. 116: The Yield Trap — Is That Dividend Real, or Is It Your Own Money Coming Back?

Imagine you just, you know, you walk up to an ATM and you slide in a crisp $100 bill.
The machine wears, it clicks and then it spits out $15 and the screen flashes.
Congratulations.
You just earned a 15% yield, right, which sounds amazing at first.
Exactly.
It sounds incredible.
But then you look at your receipt and your account balance is now just $85.
I mean, you didn't actually make $15.
The machine just, well, it handed you your own money back minus a little fee for
the privilege of doing it.
Yeah, it really is the ultimate financial optical illusion.
I mean, we are so hardwired to crave income, especially when people are planning
for retirement that we just, uh, we often completely ignore the mechanics of how
that cash actually arrived in our hands.
And that is the absolute core of our mission on today's deep dive.
We're navigating this, uh, this modern income spectrum to figure out what you
are actually buying when you chase yield.
Like when you look to your portfolio and you see a double digit yield, is that
cash actually coming from the underlying business selling more products, generating
real free cash flow?
Or is it just your own money and maybe some option premium coming back to you
dressed up as a shiny paycheck, which is such an important distinction because
to answer that we really have to establish the golden rule of income investing here.
Distribution rate is not total return and yield is not income, right?
Those terms they just get thrown around interchangeably and marketing materials
all the time, but mathematically speaking, they are completely different animals.
A distribution rate is just the percentage of a fund's net asset value that it
pays out to you over a year.
It tells you absolutely nothing about whether the fund actually earned that money.
Okay, let's unpack this because that brings up a perfect starting point on the
absolute extreme end of the spectrum.
The, uh, what we could call manufactured payouts.
Let's look at the Vista shares target 15 Berkshire select income ETF ticker,
OMA age right out of the gate.
I mean, the headline numbers on this thing are designed to grab your attention.
Oh, absolutely.
I mean, OMA H boasts a staggering 14.94% trailing 12 month yield.
And it pays out monthly, which people love.
The most recent payout was roughly, uh, 23 cents per share.
So if you just look at that 15% annualized number, it feels like you found the
holy grail of passive income 15% is huge, right?
You want to portfolio built around Berkshire halfway style equities and you're
just raking in double digit cash flow.
But applying our core question here, where is the cash actually coming from?
Because if you look at the SEC yield, which, you know, for you listening,
that's the standardized metrics showing what a fund is genuinely earning from
its underlying dividends and interest, that SEC yield is a mere point six, nine
percent.
Wow.
Yeah.
And that is the critical disconnect.
If a fund is naturally yielding less than one percent, but distributing nearly
15%, the math just dictates that the cash has to be manufactured elsewhere.
It's coming from somewhere else.
Exactly.
In OMA phase case, the fund wraps a really complex options overlay around its
equity portfolio.
And here's the revealing detail from their own filings.
Roughly 37.5% of those distributions are classified as return of capital.
So if the SEC yield is under one percent, but I'm getting 15% cash,
it's basically like taking money out of your left pocket, putting it in your right
pocket and just calling it a paycheck.
But hold on, I want to challenge that slightly.
Sure.
If the market is flat, or you know, even down a bit, isn't a 15% yield actually
a fantastic cushion.
Like, why shouldn't I just take that cash in hand today rather than waiting
around for capital appreciation that might not even come because of the asymmetric
exposure of covered call strategies, which ultimately,
that leads to NAV destruction, NAV being the net asset value, you know,
the underlying principle of your investment, right?
The actual worth of the shares exactly.
When a fund aggressively sells call options to generate a massive 15% yield,
they are capping their upside.
So if the market rockets higher, the funds gains are capped because they literally
sold away the rights to that growth.
But and this is the painful part.
If the market drops, the fund drops right along with it, they retain
100% of the downside risk.
Oh, wow.
So over multiple cycles of volatility, you know, ups and downs, you're capturing
all of the pain of the market drops, but only a fraction of the recovery when it
bounces back precisely that is the underlying issue here.
Over time, this asymmetric exposure just grinds the principle value down to dust.
I mean, if the underlying assets aren't growing enough to cover that massive 15%
payout, the fund is forced to literally liquidate its own holdings to meet its
target. They're selling the furniture to pay the rent.
Yes, exactly.
That is why 37.5% of your payout is classified as a return of capital.
They're taking money out of your left pocket, putting it in your right pocket.
And by the way, charging you a 0.95% expense ratio, just to facilitate the transfer.
That's a hefty fee for giving me my own money back.
And the opportunity cost there is just massive because if you just bought
Berkshire Class B shares directly at around what $509 a share, you wouldn't get a
monthly check.
I mean, Berkshire famously pays no dividend.
Right. None at all.
But you would capture every single percentage point of upside from those underlying
businesses compounding over time.
Only just caps that compounding in exchange for this, well, this illusion of income.
It is the archetype of financial engineering.
Now, the total return since inception is positive.
It's at 17.44%, meaning the strategy hasn't completely imploded.
But the share price itself, the NAV has declined 5%.
So your principle is actively shrinking to fund your payout.
So if giving up all our upside is the fatal flaw of standard option income
funds, there has to be a way to, you know, have our cake and eat it too.
How do we keep the growth engine running while still pulling some cash out?
Which I think brings us to a really interesting evolution in this space.
The NEO's NASDAQ 100 income ETF ticker QQ Q high.
Yeah, QQQ eye attempts to solve the exact problem we just discussed.
It holds a portfolio designed to track the NASDAQ 100 and it generates an
advertised 14.05% distribution rate.
And they do that by selling index call options.
But the mechanics of how they manage those options is where the evolution really
happens.
You know, the analogy I keep going back to here is real estate, a traditional
covered call strategy, like what we just talked about.
It's like renting out the entire upstories of your house.
You get great monthly income from the tenant, but you've completely capped your
upside because you sold away the rights to use that space.
Yeah. If you suddenly need a home office, well, too bad.
That's a very apt comparison.
Yeah. Thanks.
QQ QI alters that dynamic though.
They still rent out the upstairs, meaning they sell a call option near the
current price to generate that really hefty premium.
But then they turn around and use a small portion of that premium to buy a
further out of the money call option.
They leave the attic window open for growth exactly.
They are buying back the right to participate if the NASDAQ 100 really takes off
and experiences explosive upside.
Right. They sacrifice a tiny fraction of today's income to ensure the fund
isn't completely left behind in a roaring bull market.
And just for context on the scale of this income, a 14.05% yield on a
$100,000 portfolio, that translates to roughly 14,000 a year or about
$1,171 a month in cash flow.
That's significant.
It is scale that up to a million dollars and you're looking at 10 grand a month.
It's a very appealing number.
And beyond the mechanics of reopening that upside, there's a technical
packs advantage here that we definitely need to unpack because it fundamentally
changes the math for anyone holding this in a taxable brokerage account.
QQQI utilizes section 1256 contracts.
Let's explain why they qualify for that and why it actually matters.
Sure. Normally when you sell covered calls on single stocks that you're selling
calls on Apple or Microsoft, the premiums you collect are taxed as short term
capital gains, which means they're taxed at your ordinary income rates.
And that can be absolutely brutal at tax time.
Oh, yeah, it takes a huge bite.
But because QQI uses broad based index options on the NASDAQ 100 itself,
rather than individual stock options, the IRS treats them differently under section
1256. Yes.
Any gains from those broad index options are automatically taxed as 60% long term
capital gains and 40% short term capital gains.
Wait, regardless of holding period, exactly.
It does not matter if the fund held the contract for a week or a single day.
You get that blended, a highly favorable tax treatment, which obviously
preserves much more of that 14% yield for you after taxes.
That's a huge structural advantage.
But, you know, even with the open attic window and the favorable tax treatment,
we still have to confront the math of NAV erosion.
We do because it is an inescapable law of finance.
What's fascinating here is if your fund pays you an income of 15%,
but the underlying growth of the fund's assets is negative 5%, your total
return is only 10%.
Whenever your total return is less than your distribution rate,
you are suffering NAV erosion.
The principal value of your investment is just slowly dissolving.
Over a 30 year retirement, relying on an eroding asset base is a precarious
strategy, no matter how tax efficient the payouts are, which marks a really
natural pivot point on the income spectrum today.
Because once you see the risks of financial engineering and these options
overlays, the pursuit of reliable sleep at night income naturally shifts away
from manufactured yields.
You start looking for cash that is backed by actual tangible business profits.
Yeah, we move from the engineers to the honest compounders.
I love that phrase.
Yeah.
And the heavyweight champion in this category is the Schwab US dividend equity ETF
ticker, SCHD.
The contrast here is just stark.
There are no options overlays, no return of capital, no complex
tax loopholes.
It is purely real cash generated by the expanding profits of some of the
most established companies in the world, being passed directly to the shareholders.
And the underlying metrics of SCHD, they just perfectly illustrate the
power of plain vanilla compounding.
The expense ratio is virtually negligible.
It's at 0.06%.
Basically free basically.
And since its inception in 2011, the share price itself, the underlying NAV has
grown by 9.75% annualized.
And when you factor in the dividends being reinvested along the way,
the average annual total return climbs to 13.3%.
But the tradeoff, of course, is the current yield.
I mean, it's it's modestly between 3.14 and 3.3% for someone who was just
looking at 14% options yields, 3% feels incredibly boring.
Oh, I might feel boring today, sure, but the excitement lies in the growth rate.
That 3% is backed by free cash flow machines.
We're talking about companies like Abbott Laboratories, Amgen Merck,
because these underlying businesses are constantly growing their profits,
they're constantly growing their payouts.
Right dividends go up.
Exactly.
Over the last five years, the companies inside SCHD grew their dividends by
9.4% annually.
Consequently, SCHD's own payout to its investors compounded at an 11.2% annual rate.
Here's where it gets really interesting.
If you map this against the rule of 72, the mathematical power just becomes
obvious at a 9.75% annualized price growth.
The principal value alone of SCHD doubles by roughly 2034.
But if you take those dividends and reinvest them capturing that full 13.3% total
return, you pull that doubling timeline up to 2032.
You are actively expanding your capital base while collecting a passive income
stream that outpaces inflation year after year because the dividend is simply
a natural byproduct of owning highly profitable businesses.
The cash is coming from selling pharmaceuticals and consumer goods,
not from selling your own principal back to you.
I totally understand the compounding argument.
But, you know, let's look at this from the perspective of a retiree who just
stepped out of the workforce.
A 3.1% yield on a half million dollar portfolio is only about $15,500 a year.
That might not be enough to cover rising property taxes, health care groceries
today. They cannot wait until 2032 for the income to double.
So how do we find yields of 4% or higher that are still entirely covered by
actual business profit?
Well, it requires looking past the broad index ETFs and doing really
rigorous, fundamental screening of individual companies.
We have some great research from Kiplinner detailing a strict methodology
for finding these durable, high yielding names.
The criteria are unforgiving.
What are the rules?
A stock must have a minimum 4% current yield.
It must demonstrate at least 10 consecutive years of stable or growing dividends.
And most crucially, its payout ratio can be no more than 60% of its estimated
2026 earnings per share.
That's 60% threshold is key.
That's the ultimate margin of safety.
It means that for every dollar the business earns, they are handing out a maximum
of 60 cents to shareholders.
They're keeping 40 cents in the word chest to whether a session's pay down debt
or, you know, invest in new growth.
Exactly.
One of the companies that clears this hurdle is Fidelity National Financial ticker FNF.
It currently yields 4.1%.
But it is only paying out about 40% of its projected 2026 earnings.
Another prime example is American tower ticker AMT, which yields 4.3%.
Now, wait, American tower has taken a pretty big beating recently.
I think they're down roughly 25% over the past year.
When a stock price drops, the dividend yield artificially inflates.
So how do you know that 4.3% isn't just a yield trap?
By understanding the mechanics of their specific business model,
American tower operates cell towers globally.
The steel is already in the ground.
The maintenance costs are relatively low.
They sign major telecom carriers to long-term five to 10-year leases
that include built-in mandatory rent escalators.
Now, the revenue is locked in.
Exactly.
The cash flows are highly visible and contractual.
Even with the recent stock price decline, mostly due to macroeconomic interest rate fears,
their dividend only consumes about 70% of their FFO.
OK, let's define FFO for anyone venturing into real estate investments.
Because looking at traditional earnings for a real estate trust will give you a heart attack.
FFO stands for funds from operations.
Right.
When you look at standard EPS, earnings per share, accounting rules require companies
to deduct depreciation, but real estate typically appreciates in value over time.
Forcing a company to depreciate $1 billion of real estate on their income statement
makes their standard earnings look artificially abysmal.
It looks like they're losing money when they aren't precisely.
FFO simply adds that paper depreciation back into the equation.
It gives you an accurate, transparent view of the actual cash the properties generated that year.
And speaking of true cash generation in real estate,
we have to examine the ultimate durable rung on our income spectrum today.
Realty income ticker O.
There's actually a critical timing element here for anyone listening.
July 31st is the deadline to own shares before their August 5th earnings call.
If you want to capture the next payout, real T income is practically an institution in the dividend space.
They recently announced their 135th dividend increase.
They pay $3.25 per share annually yielding 4.9%.
But if you pull up a basic stock screener and look at their traditional price to earnings ratio,
it sits at 54, which looks terrifying.
A PE of 54 implies extreme overvaluation for a slow growing real estate company.
But again, PE is the wrong diagnostic tool here.
When you evaluate them using the proper metric priced FFO,
they trade at a very reasonable multiple of 15 based on their 4.26 dollars in trailing funds from operations.
The valuation is completely sound.
The beauty of real T income is the source of the cash.
We aren't relying on a portfolio manager successfully navigating options of volatility like with all major QQQI.
We are relying on legally binding triple net leases collected from grocery stores, dollar stores, pharmacies.
Businesses that sell absolute necessities rain or shine.
Yeah, it has contractual rent protected by the fact that their tenants are usually responsible for the taxes,
insurance and maintenance of the properties.
The cash flow is fundamentally insulated.
So S.C.H.D relies on diversified corporate profits and real T income relies on legally binding rent.
Both are incredibly durable.
But this brings up a really tough question for anyone holding legacy dividend stocks.
What happens when a historically safe model, a literal dividend king,
start showing massive cracks in its foundation?
Let's talk about Pepsi go ticker P.P.
Pepsi go is the perfect cautionary tale of why you can never buy a stock purely for its aristocratic history
and then just fall asleep at the wheel.
It is a beloved global consumer staple sure that the stock is currently down 30% from its 2023 peak.
The performance gap between Pepsi and the broader market right now is just stunning.
Over a five year period, Pepsi's total return, and this is even with those historically safe dividends reinvested,
it's a meager 1.86%.
Over that exact same five year window, the S&P 500 delivered a total return of nearly 80%.
It's a massive underperformance.
Yeah, even their direct rival, Coca-Cola, posted a 67% total return.
So is Pepsi simply a misunderstood value play right now or is it a falling knife?
Well, the bull case hinges entirely on valuation and your diversion.
Pepsi's forward yield is 4.33%.
Relative to its own history over the past five years, that puts the yield in the 98th percentile.
It has rarely been this cheap since the depths of the 2009 financial crisis.
Wow.
And its forward PE is 15.97.
So the argument is simple.
If the market eventually re-rates Pepsi back to its historical median valuation,
the stock price climbs to $178 offering a 30% upside on top of that 4.3% yield.
I mean, buying a blue chip monopoly at a crisis level discount is always tempting.
But what does the foundation look like underneath that?
What is the bear case?
The bear case reveals severe underlying payout stress.
If we connect this to the bigger picture, the dividend growth is rapidly decelerating.
A few years ago, Pepsi was handing shareholders 10% annual raises.
Yeah, but the most recent increase was just 4.04%.
And the metric that should have every single income investor paying attention is the payout ratio.
Their ETS payout ratio is projected to hit 92.7% in 2025.
Imagine running a lemonade stand where for every dollar and profit you make,
you are forced to hand 93 cents right back to your investors.
You only have 7 cents left over to buy more lemons, fix your sign or, you know, open a second stand across town.
You aren't operating a growth business anymore.
You are a hostage to your own dividend.
That is the exact reality of a 93% payout ratio.
It starves the business of the capital required to innovate or acquire new brands.
Now, look, Pepsi is still a massive cash machine.
They generated $9.28 billion in trailing free cash flow.
The problem is trajectory that free cash flow has only grown at a 1.85% compound annual rate over the last decade.
It has essentially flatlined against inflation.
If they are paying out nearly 93% of their earnings just to maintain their dividend king status and, you know, keep the yield chasers happy today,
they are cannibalizing their own capacity for future growth.
Unless the underlying business somehow magically accelerates its free cash flow,
your total return is likely going to be trapped at just that 4.3% dividend.
It perfectly illustrates the danger of focusing on the payout rather than the health of the underlying engine.
We have covered massive ground across the income spectrum today.
We started at the extreme edge with MAH's 15% manufactured yield,
exploring how asymmetric options exposure can just lead to an EV destruction and a return of your own capital.
Then we looked at QQQ-wise evolution using section 1256 contracts and leaving that upside window open.
We moved to the honest compounding of SCHD and the strictly screened rent-backed cash flows of fidelity national,
American tower, and realty income.
And finally, we saw how a 93% payout ratio can turn a legendary dividend king-like Pepsi into a potential yield trap.
Yeah, and if you take away only one lesson from navigating this spectrum, let it be this yield is not income.
Total return is the only metric that ultimately dictates the survival and purchasing power of your portfolio.
You must always look past the headline percentage, dig into the mechanics and ask where is this cash actually coming from?
So what does this all mean?
It leaves us with a final, slightly provocative thought to consider.
If manufactured yields often just return your own money and historically safe dividend kings are stretching themselves to the breaking point to maintain their payouts,
could the safest, most powerful income strategy of the future actually involve companies that pay absolutely no dividends today?
Oh, that's an interesting thought.
Right. Companies that relentlessly reinvest every single dollar of free cash flow into compounding their own value.
So that when you finally do need to manufacture your own income by selling a few shares in retirement, the underlying asset base is just massive.
It requires a massive mindset shift, though, from immediate gratification to total return compounding.
You have to let the business build the engine, rather than bleeding it dry for cash today.
Because ultimately you want a portfolio that builds lasting wealth, not an ATM that slowly hands you your own money back.
Thank you for joining us on this deep dive.
Go take a hard look under the hood of your own portfolio's yield and make sure you know exactly who is funding that paycheck.