Ep. 120: The Yield Reality Check — Real Income vs. Manufactured Yield

Imagine walking into like a really high-end restaurant, right?
Okay, found with you.
And the waiter brings out this absolutely massive, perfectly cooked steak.
It's huge, exactly what you wanted.
And the best part is, the menu says it's completely free.
That sounds like a scam already.
Right. But you eat the whole thing, you're feeling great.
And then you get your credit card statement the next month.
And you realize the restaurant just quietly charged your own account to pay for the meal.
Oh, man.
You didn't get a free steak.
You just bought yourself a really expensive dinner without realizing it.
And honestly, yield investing right now feels exactly like that restaurant.
It really does.
It's, well, it's the ultimate psychological trap in finance.
Yeah.
Because we are wired to look at a high yield percentage and immediately calculate,
you know, how much passive income that would generate for our lifestyle.
Oh, absolutely.
Like, if I have a hundred grand, I may contend great a year.
Easy.
Exactly.
But a big yield number is just a billboard.
I mean, it tells you absolutely nothing until you understand the underlying engine.
And that is exactly our mission for you on today's deep dive.
We are doing a massive yield reality check.
Long overdue, honestly.
Right.
Because the entire premise here is to audit what is actually funding these huge payouts.
We're going to tear down the mechanics of what we call manufactured yield.
The stuff that looks great on paper but might just be cannibalizing your principle.
Yes, exactly.
And then we're going to pivot to real actually funded income backed by physical cash flows,
including a massive contrarian yield hiding right in plain sight.
So the dividing line we really need to establish right away is how the cash is being generated.
Right.
Is it coming from a real business producing surplus cash or is it being, you know,
engineered through leverage and derivatives and just aggressive accounting?
Okay, let's unpack this illusionist trick for a second.
Let's look at one of the heavyweights in the manufactured yield space.
PDI.
Yep, PDI.
The PMFCO dynamic income fund.
This is an extremely popular closed-end fund and it is currently boasting a staggering 16.5,
2% trailing 12-month yield.
Which is just a massive number.
If I put a hundred grand in, I'm supposedly getting over $16,000 a year.
But when you look at the chart, there's a glaring problem.
Just a little one.
Yeah, just a small issue where since its inception in 2012,
the NAV, the actual share price of the fund,
has completely melted down by about 36%.
Yeah, and to understand that price decay, you really have to look at the mechanics of how they're
generating that 16.5%.
Okay, break that down for us.
So PDI is an actively managed fund, right?
They're buying global credit.
Things like mortgage back bonds and high yield corporate debt.
Which pay pretty well, but not 16%.
Exactly.
Those underlying bonds do not pay anywhere near that.
So to get the yield up, the fund uses heavy leverage.
They borrow short-term money to buy more long-term higher yielding bonds.
But borrowing money isn't free.
I mean, especially over the last couple of years with rates where they are.
Far from it.
And that is where the hidden drag comes in.
Because when you factor in the management fee and the interest expense on all that borrowed money,
the all-in-expense ratio for PDI is a staggering 4.46%.
I need to stop you there.
4.46% just to hold the fund.
Yep.
Why on earth would I pay that?
Like, if I'm buying a standard index fund, I'm paying maybe 0.05%.
Right.
Even an aggressive options fund might charge like 0.7.
A 4.46% hurdle rate means the fund managers have to generate nearly 5% in returns every single year
just to break even before I see a single dime.
You are hitting on the exact
structural headwind.
That fee just compounds aggressively against your capital.
And because PDI is a closed-end fund,
the market price can actually detach from the actual value of its holdings.
Oh, right.
The premium.
Yes.
Investors chase that 16.5% yield so hard that they regularly buy the fund at a premium.
Recently, that premium average around 8.5%.
Which is wild.
And it spiked as high as 17.6%.
Meaning, I am paying a dollar and 17 cents just to buy $1 worth of underlying bonds.
Which immediately suppresses my true yield because I'm overpaying for the asset that's generating
the cash.
Right.
And to add insult to injury, these distributions are mostly taxed as ordinary income.
Oh, wow.
Yeah.
So if you hold this in a taxable account,
you're getting hit with up to a 37% tax rate on that cash flow.
Ouch.
But here's the crazy part.
Despite all of that, the massive fees,
the leverage costs, the shrinking NAV, the total return of PDI since inception is actually
up nearly 280%.
Wait, let me get this straight.
The share price drops 36%.
But the total return is up 280%.
That means the entire return profile of this investment relies completely on the cash distributions.
That is the critical takeaway right there.
Because total return assumes you are reinvesting every single monthly distribution back into the fund.
But no one doing that is buying a 16% yield.
Exactly.
Most people buying that yield aren't reinvesting it.
They are spending it to live on.
So a fund where the share price drifts downward while the total return compounds upward,
it's mathematically just handing you its own value as cash.
Like the stake dinner.
Exactly like the stake dinner.
It is an aggressive conversion of future price stability into immediate,
highly taxable cash flow.
And if the bonds hit a rough patch, they just hand your own money back.
Yes.
They have to return your own capital to maintain the illusion of the yield,
which just accelerates the NAV decay.
Okay.
Which brings us perfectly to the newer trendier way Wall Street is manufacturing yield.
Uh, yes, the derivatives.
Right.
Because of borrowing money to buy bonds is the old way.
The new way is options.
Let's talk about BGY.
The yield max targeted 12 big 50 option income ETF.
Catch your name.
Super catchy.
And the strategy sounds amazing on paper.
I mean, they hold the top 50 US companies, the tech giants, right?
Apple, Nvidia, Microsoft.
And they target a 12% yield by running a covered call strategy on them.
And this is where we have to introduce the SEC yield reality check.
Please do.
So SEC yield is a standardized metric.
It basically measures how much money a fund actually collects
from traditional organic dividends and interest over a 30-day period.
Real money.
For BGY, that SEC yield is only 0.28 percent.
Less than a third of 1 percent.
So if they're only generating 0.28 percent
from the actual companies paying dividends,
the other 11.7 percent is entirely manufactured out of thin air using options.
It's manufactured by selling away your future basically.
Explain that.
So a covered call strategy means the fund owns the underlying tech stocks,
but they sell call options against them.
They're making a deal with the options market,
basically saying, give us cash right now today.
And in exchange, if Nvidia or Apple goes on a massive run this month,
you get to keep all our upside gains above a certain price.
So they are constantly putting a ceiling on their biggest winners.
And they do this because they have an incredibly rigid strategy,
right?
They pay out exactly 1 percent of their NAV2 investors every single month,
regardless of what the market is doing.
And that rigidity is the fatal flaw.
Just think about the math of a 1 percent monthly drain.
When the market is ripping higher,
BIGY's upside is capped by those covered calls.
Like when Nvidia jumps 15 percent in a month,
BIGY only captures a fraction of that.
Right.
But when the market drops,
they have full downside exposure.
The small premium they collect it from selling the option
acts as a tiny airbag,
but they still take the brunt of the equity loss.
So if the underlying portfolio drops 10 percent,
BIGY's NAVy drops roughly 9 percent.
Right.
But they're still committed to paying out 1 percent of whatever is left.
Exactly.
They drain 1 percent from a shrinking pool of capital.
It makes recovering the original value nearly impossible
unless you're diligently reinvesting those monthly dividends.
Which again, people aren't doing.
No.
And you can see the structural lag in their performance.
Year-to-date in a massive bull market for tech.
BIGY's total return was roughly 4.64 percent.
Bouch.
Massively underperforming the S&P 500.
I mean you're paying a 1.09 percent expense ratio
for a strategy that mathematically guarantees you'll underperform a bull market.
While still forcing you to ride the elevator down during a crash.
Exactly.
Well here's where it gets really interesting.
Because if the fatal flaw of a covered call ETF
is that it caps your upside in a bull market,
investors naturally start looking for a strategy
that keeps the upside completely open.
Right.
So does a strategy like that exist?
And more importantly, does it actually work?
This leads us to OVL.
The overlay shares large cap equity ETF.
OVL is a fascinating attempt to solve that covered call problem.
It boasts a yield of around 10 percent.
But unlike BIGY, it doesn't cap the upside.
Right.
Because OVL actually holds 100 percent of the S&P 500 index
directly through the Vanguard VOO ETF.
Okay, so if they hold the S&P 500 and they aren't selling covered calls.
Where's the 10 percent coming from?
They use a completely different derivative strategy
called a CUT spread overlay.
Okay.
So instead of selling calls, they sell PUT options.
When you sell a PUT, you're collecting a cash premium right now
in exchange for agreeing to buy the market
if it drops below a specific price.
But normally a broker requires you to hold mass amounts of cash
as collateral to back up a bet like that.
Exactly.
And OVL gets around this cash drag
by turning it into a spread.
Walk me through the mechanics of that spread.
Sure, let's say they sell a PUT option
and collect a thousand dollars in premium.
Right.
They immediately take a portion of that thousand dollars
and buy a cheaper, lower-strike PUT option
further out of the money.
Uh-huh.
That second PUT acts as a hard floor.
It mathematically caps their maximum possible loss on the trade.
And because the risk is now strictly defined,
the broker doesn't require them to sideline cash.
The S&P 500 shares they hold act as the collateral.
Clever.
So they are making a bullish bet.
As long as the market stays flat or goes up,
they keep the net premium from that PUT spread.
They pay it out to hit their 10% target.
And I still get the completely uncapped equity gains
of the S&P 500.
That is the theory.
Yes.
Okay, but there is always a catch.
Because they aren't capping their upside.
But by writing these PUT options,
they're essentially acting like an insurance company, right?
Yes.
Like they're writing policies for other investors
who want downside protection.
So if the market crashes slowly,
aren't they just paying out insurance claims week after week
while hoping their premium income covers the losses?
That insurance analysis absolutely spot on.
And the data bears out exactly how painful that can be.
The PUT spread strategy is decent at cushioning sudden
minor market dips, but it is fundamentally destroyed
by a relentless slow bleed market.
Like 2022.
Exactly like 2022.
As interest rates climbed in the market slowly ground lower,
week after week, month after month,
OVL was getting crushed.
Their short prints were constantly expiring in the money.
Meaning they were losing on those derivative bets
over and over again.
Precisely.
So not only are they taking the underlying loss
of the S&P 500 dropping.
They are taking additional losses on the options desk.
Yep.
They underperformed the S&P 500 by about 5% that year.
And here is the ugliest part of the mechanics.
Tell me.
Because they're committed to paying out that high yield,
when the options desk is losing money,
they have to fund the distribution from somewhere.
So in 2023, up to 78% of their distribution
was classified as return of capital or ROC.
Wow.
So nearly 80% of the cash they handed investors
was just the investor's own principal being handed back to them
just to maintain the illusion of a 10% yield.
Exactly.
I mean, if I want to sell 10% of my portfolio year,
I can just hold the S&P 500 directly
and sell this shares myself for practically zero fees.
I don't need to pay an ETF manager
to do it for me while taking on options risk.
Which perfectly isolates the danger of manufactured yield.
It requires constant, active financial engineering.
And the moment the market environment shifts away
from what the algorithm expects,
the engine just starts chewing up your principal.
Man.
Okay, so let's pivot entirely away from financial engineering,
derivatives, leverage, all of it.
If we wipe all of that off the table,
what does a high yield look like
when it's funded by tangible real world cash flow?
Right.
And this brings us to the physical world,
specifically midstream energy companies.
These are the physical pipelines,
the processing plants,
the storage facilities that move oil
and natural gas across the continent.
And this is where we find a really fascinating intersection
between old school physical infrastructure
and cutting edge technology.
Because the major catalyst driving the cash flow
in the sector right now
is the artificial intelligence data center boom.
Wait, really?
You wouldn't normally put those two together.
Yeah.
I mean, AI feels like it lives in the cloud
and pipelines are literally buried in the dirt.
I know, but the cloud requires massive amounts
of physical electricity.
A modern AI data center can draw anywhere
from 50 to 100 megawatts of power.
That's huge.
It's massive.
The projections indicate that the power demand
from US data centers is going to be so huge
that natural gas demand will jump
up to 6.1 billion cubic feet per day by 2030.
Wow.
That is a 20% increase in power sector burns
strictly to feed the AI boom.
Wait, I have to challenge that premise, though.
The whole world is talking about the green energy transition.
Sure.
So why are Wall Street analysts
rating traditional fossil fuel infrastructure
as a screaming buy
when we're supposedly moving toward wind and solar?
Like, shouldn't natural gas be a dying business?
It comes down to the physical limits of the power grid.
Wind and solar are intermittent energy sources.
Right.
The wind stops blowing.
The sun goes down.
But an AI data center running billions of calculations
cannot tolerate intermittent power.
If a data center loses power for even a fraction of a second,
it disrupts massive computational workloads.
They require reliable 24.7 baseload electricity.
So they need gas?
Right now.
And for the foreseeable future,
the only way to guarantee that uninterrupted
massive scale of power locally is by burning natural gas.
And the midstream companies operate like a toll road
on that energy superhighway.
Exactly.
Because they don't care about the daily price of the commodity,
right?
They just charge a fee for the volume
moving through the pipe under long-term contracts.
So the cash flows are intensely predictable.
Very predictable.
And the yields here are very real and deeply funded.
Let's look at some tickers.
Energy transfer, ticker ET,
is paying 6.71%.
MPLX is yielding 7.16%.
Plains all American, PAA is at 6.43%.
And Western midstream, WES is at 7.86%.
The one logistical hurdle for you as a retail investor, though,
is that many of these companies are structured
as master-limited partnerships.
Oh, the K-1.
Yes.
That means instead of a standard tax document at the end of the year,
you get a complicated K-1 form,
which can just be an absolute headache for your accountant.
Yeah, nobody likes a K-1.
But there are ETFs like AMLP
that bundle these midstream companies together.
It currently yields around 7.86%,
and it issues a standard 1099 tax form
bypassing the K-1 issue entirely.
Which is great.
It's actual cash from a physical service.
Yeah.
And the data shows this concept of real yield
isn't just limited to energy either.
Right.
If you want structural outperformance
and traditional fixed income,
without resorting to PDI's leverage tricks,
you can look at HYZD.
The wisdom tree interest rate hedged high yield bond fund.
This is a brilliant example of how you can achieve real yield
just by correctly positioning for macroeconomic physics.
We all know that when interest rates rise,
traditional bond prices get crushed, right?
The Bloomberg US aggregate index,
which is the standard benchmark for bonds,
had a duration of over six years
during the recent rate hikes,
meaning it took massive capital losses.
Over the last decade,
it only returned a meager 16.56% total.
It completely failed to keep up with inflation.
But HYZD survived that.
It thrived, actually.
HYZD is an interest rate hedge strategy.
They hold high yield corporate bonds,
but they short treasury futures against them
to neutralize the interest rate risk.
Oh, interesting.
Yeah, so their effective duration is just 0.21 years.
That means they're virtually immune to rate hikes.
They successfully beat inflation over the last decade,
simply by isolating the credit yield
and hedging out the interest rate risk.
Wow.
It is real yield funded by corporate debt
protected by a mechanical hedge.
OK, so we've broken down engineered dividends
melting your NAV and physical dividends
driven by the AI boom.
Now, let's explore a completely different metric of yield,
free cash flow yield.
Yes.
And we're finding it in arguably the market's
most hated out-of-favor sector right now.
The cable and telecom space.
It is the absolute definition of a contrarian value play.
It is deeply unloved.
I mean, you look at Verizon trading under 10 times earnings
at around $46 a share despite their massive cash generation.
But the most staggering fundamental number
in all of the data we reviewed
belongs to charter communications.
Charter represents a massive dislocation
between market sentiment and underlying cash flow.
The stock is trading around $123 a share.
OK.
Yet analysts are projecting that charter
will generate roughly $63 of free cash flow per share
next year.
That's insane.
So what does this all actually mean?
Let's ground this in a real estate analogy
so the map hits home for you.
Please do.
Imagine buying a rental house in your neighborhood
for $100,000.
And that house generates $50,000 a year
in pure, unencumbered profit.
I take that deal in a heartbeat.
Right.
That is a 50% free cash flow yield.
In real estate, you would mortgage your life away
to buy that house.
But in the stock market, charter
is trading at those exact metrics
and people are terrified of it.
Why is the cash flow suddenly so high?
Well, it's not because charter is experiencing
some sort of hyper-growth renaissance.
It is purely a function of the capital expenditure cycle.
For the last several years,
charter has been spending billions of dollars
upgrading their physical networks.
Those infrastructure projects are finally wrapping up.
So when your capital expenditures plummet,
all the revenue you're taking in suddenly
drops straight to the bottom line as free cash flow.
OK, but the market isn't stupid.
If a company is generating a 50% free cash flow yield,
there has to be a reason investors are
treating it like a toxic asset.
True.
Going back to the rental house analogy,
it's like buying that $100,000 house yielding 50%.
Strictly because everyone in the neighborhood
is convinced someone is going to invent
flying houses next year
and render ground-based real estate entirely obsolete.
That's a great way to put it.
What is the flying house?
That has Wall Street so spooked.
The flying house is SpaceX's Starlink.
The market has basically priced in a narrative
that satellite internet is an existential
extinction-level threat to traditional broadband cable providers.
But Starlink isn't a myth.
I see the dishes on people's roofs.
It's in the sky right now.
Why does the data suggest Wall Street is overreacting?
Because Wall Street is ignoring the laws of physics.
Starlink is a phenomenal technology
and it is a perfect solution
for deeply rural low-density areas
where laying physical cable is cost prohibitive.
Right.
But satellite internet relies on spot beams
from low-earth orbit.
A spot beam covers a wide geographical area
but it has a fixed amount of total bandwidth.
Meaning if one farmhouse is using that beam,
they get blazing fast internet.
But if you drop that same spot beam
over a dense suburban neighborhood with thousands of homes.
The math collapses.
If thousands of suburban homes try to stream 4K video
simultaneously on a single spot beam,
the network bottlenecks immediately.
The physics of satellite bandwidth simply cannot scale
to handle the user density of a typical urban
or suburban environment.
Makes sense.
Traditional broadband,
which runs a physical hardwired pipe directly
into the neighborhood,
doesn't have that density limitation.
So the market is brutally punishing
charter's valuation based on a competitor
that structurally cannot steal their core
high-density customer base.
Is the Mirage we talked about at the beginning,
but working in reverse?
Exactly.
Instead of seeing water that isn't there,
investors are seeing a monster
that can't actually reach them
and they are sprinting away
from an incredibly real massively funded pool
of free cash flow.
And that really ties everything we've discussed together today
because whether you're analyzing
a 50% free cash flow yield in telecom,
a 7% physical distribution from a midstream energy pipeline
or a 16.5% payout from a leverage credit fund,
the due diligence process does not change.
The billboard number means nothing.
You have to audit the funding.
You have to ask yourself,
is this cash coming from real people
paying their gas and internet bills every month,
or is it coming from an options premium
that caps my upside
or borrowed money that melts my principle?
And as you review your own portfolio,
I just want to leave you with one final
kind of unsettling dynamic to consider.
What's that?
Most of these complex, high yielding derivative strategies,
you know, the covered calls, the putsbreds,
they have been battle tested
in relatively contained markets
or in slow grinding draw downs.
But what happens to manufactured yield
when a true, violent, black swan event hits the market?
Well, man.
When volatility goes completely vertical
and options markets freeze up and gap down overnight,
will that manufacturer, 12% yield,
act as a life raft to keep you afloat?
Or will the derivatives contract turn into an anchor
that irreversibly drags down the principle you rely on?
The very vital question to keep in mind
is you check under the hood of your own income engines this week.
Thank you for joining us on this deep dive.
We'll see you next time.