Ep. 149: Yield vs. Return After the Fed's First Hike

you know, usually when you walk into a store and you see a giant red 50% off sticker on a TV,
you know exactly what that means. Right. You're getting a discount. The TV's the same.
Just cheaper. Exactly. The intrinsic value hasn't changed at all. Just the price you pay at the
register. But if you step into the world of income investing, especially literally right now,
that red sales sticker might actually just be a giant warning label. Yeah. That's really the core
of the issue we're facing. In, you know, equity and bond markets, a sharply-roising yield is rarely
ever a discount sign. Like more often than not, it's a it's a distress signal flashing bright red.
Which brings us right into today's deep dive. So for everyone listening, we are recording this on
Thursday, September 17th, 2026. And the entire market is basically waking up to a starkly different
reality today. Oh, absolutely. Yesterday was a big deal. Yeah. I mean, yesterday the Federal Reserve
hiked interest rates by a quarter point. Yeah. So that brings the target range to
3.75 to 4% unanimous 12 to 0 vote, which makes it their first increase since what July 2023. Yeah,
July 2023. But the detail that's really sending shockwaves through the market right now isn't just the
hike itself. It's the projection. Right. The projection. Yeah. They are projecting absolutely
zero rate cuts through the entirety of 2027. None. Which is wild. It changes everything that
that hole higher for longer stands. It fundamentally alters the like the molecular structure of the
markets because of 4% risk-free rate locked in for years. It basically becomes this invisible gravitational
pole on every single asset you own. It reprices risk across the entire board. And that is exactly our
mission for this deep dive. We are looking across your stack of sources across the landscape of
income investing to figure out exactly what this new interest rate reality actually does to a portfolio.
We're going to examine, you know, leverage, preferred, option income ETFs and some wildly popular
dividend stocks. And as we unpack all these strategies, there is one core mantra that I mean it
really should govern every single decision you make in this environment. What's that yield is not total
return and a high yield is not a discount. Okay. Let's unpack that. Let's start with the
investments that are most immediately vulnerable to yesterday's Fed rate hike. We really need to
talk about leveraged rate sensitive assets. Oh, yeah. The prime suspects right now. Right. And a
prime example sitting out there is the vertus infer cap US preferred stock ETF. The ticker is PFFA.
Now, if you just look at the surface, PFFA boasts this massive 10% monthly yield and it's trading near
it's 52 week low. It's at around $20.51. So the pitch you see everywhere online right now is that
this fund is basically a screaming bargain. Yeah. And we really need to take that a step further and
look at the actual mechanics of what this fund holds because honestly that pitch is incredibly
dangerous. How so? Well, PFFA is an actively managed fund that buys preferred stocks. And for those
who might not track them super closely, preferred are essentially hybrid securities, right? They pay
a fixed dividend kind of like a bond, but they're perpetual. They usually have absolutely no maturity
date. Right. They just keep paying forever. Exactly. But because that payment is fixed forever, their
evaluations are extremely sensitive to interest rate movements. So when the Fed hikes rates like they
did yesterday, newer bonds offer better yields. So the value of those older fixed preferred payments
just drops dragging the underlying share prices down with them. But the declining share prices
and even the whole story with PFFA isn't because the fund doesn't just hold these preferred stocks
outright. They apply about 25% leverage to the portfolio. Right. They're literally borrowing money
to buy more shares. And that is exactly where the trap snaps shut because they borrow at short term
floating rates to fund that 25% leverage. So when asset prices fall, the leverage amplifies the decline.
But the truly hidden danger here is in the operating costs. Yeah, I wanted to bring this up.
PFFA has a stated total expense ratio of 2.11%. And I think investors often just assume
that's the cost of the portfolio managers picking the stocks. Right. They think it's just a management fee.
But I looked closely at the breakdown of those fees and the sources and it's a striking detail.
The actual management fee is only 0.80%. Yeah. Which means 1.3, 1% of that total fee is strictly
leverage interest. Like think about the mechanics of what literally just happened yesterday.
The rate hike. Exactly. As the Fed hiked rates, the cost to hold this fund mechanically climbed
overnight. If you own this fund, you're paying for floating rate liability in the exact economic
environment that is simultaneously crushing the value of the underlying asset. Man, that's brutal.
Yeah. The cost of borrowing is rising while the stuff you bought with that borrowed money is just
falling. It's like claiming PFFA is on sale just because a deal went up is like being thrilled
your car's pedometer is reading a record high. Yeah. Only to realize it's just because you're rolling
down a steep hill and the brakes completely failed. That is a perfect analogy. A yield that rises
simply because the underlying share price collapsed. I mean, that's just a shrinking denominator.
It isn't a discount. No, not at all. And what's truly fascinating and honestly a bit concerning is
looking at how funds under this kind of pressure try to manage investor perception. Oh, the return
of capital thing. Yes, let's look at the return of capital or ROC discrepancy. So funds issue
what are called 19 A notices. These are preliminary estimates sent to shareholders explaining where
their distribution is actually coming from. Right. Well, back in February of 2026, PFFA's 19 A notice
showed the return of capital estimate literally doubled to 13.5%. And it has stayed at that elevated
level for seven straight months. Okay, wait, just to be clear for everyone, they are estimating that
13.5% of the yield they're paying out isn't actually investment income. It's just the investor's own
principle being handed back to them to like artificially inflate the yield. That is the direct
implication of the estimate. Yeah. However, and this is where it gets crazy, if you pull the audited
financial statements for the three months following that initial spike. The official books claim
the return of capital was absolute zero. Wait, really? Zero. The internal estimates and the final
audited books just flatly disagree. And you know, this often happens when a fund is under severe margin
compression from rising borrowing costs and falling asset values. The true character of the cash
they're paying you gets very murky as they just try to buy time and maintain the headline yield.
Geez. So what does this all mean for the investor who, you know, still genuinely wants exposure
to preferred stocks because they aren't all bad. Right. And the contrast here is PFF. PFF is the
passive unleveraged alternative. It only charges a 0.45% fee. It doesn't use 25% leverage, which means
its operating costs don't mechanically shoot up when the Fed hikes rates. Right, but the yield is
lower. Yeah, you have to settle for a lower yield. It's around 5.5%. But you aren't walking blindly
into a leverage trap. It perfectly illustrates our core mantra yield is not total return. PFF
protects your actual principle in a rising rate environment much more effectively than PFFA does.
Yeah, even if the headline yield doesn't look as flashy on a screening tool, preserving your capital
has to be step one. But you know, preferred stocks aren't the only assets catching the brunt of
these rising rates. Real estate is heavily exposed to. Oh, absolutely. Real estate is huge here.
And if we look at how investors traditionally build a real estate portfolio, there is this
serious misconception about diversification. The sources call it the REIT portfolio roast.
Many people believe that simply holding like one or two famous real estate investment
trusts or REITs means they have their real estate allocation completely covered. And it's just a
fundamental misunderstanding of the sector. The real estate market is incredibly fragmented. So
true diversification requires deliberate exposure across entirely different operational subsectors
because they respond to totally different economic drivers. Give me an example of that.
Well, for instance, you might hold equinix for data centers, which is driven by the secular tailwinds
of AI and cloud computing. Okay. Yeah. Then you might pair that with East Group properties for industrial
and shallow bay distribution centers in like high growth sunbelt markets or invitation homes for
residential single family rentals. Piling your entire allocation into a single retail focused
REIT is a concentrated bet. It's not a diversified real estate strategy, which perfectly sets up the
ultimate test case we really need to examine today. Realty income ticker O versus Johnson and Johnson
ticker J and J. Oh, this is a classic comparison. It is. I mean, realty income is practically a religion
for a lot of retirees. It pays a juicy 5.2 6% monthly yield. They literally trademarked the phrase
the monthly dividend company. They did. But in this newly solidified 4% fed rate environment,
we have to look past the marketing and examine the actual balance sheet. Realty income currently
carries a net debt to EBIT ratio of 7.9 X. Wow. Nearly eight times. Yeah. And for context, EBIT
stands for earnings before interest taxes depreciation and amortization. It's basically a proxy for
the raw operational cash flow of the business. Right. So only nearly eight times your annual cash flow
is a massive amount of leverage in a world where refinancing that debt is going to be a significantly
more expensive for the foreseeable future. Yeah, because rates are getting cut till 2028 at the earliest.
Exactly. And furthermore, roughly 66% of realty incomes annualized base rent comes from non-investment
grade tenants. Wait, 66%? So if this higher for a longer rate environment actually slows the
broader economy down and those lower tier retail tenants start struggling to make margins,
that sacred monthly check suddenly looks a lot less secure. The margin of safety is definitely
compressing without a doubt. Now, contrast that risk profile with Johnson and Johnson.
J&J pays quarterly and its headline yield is a very modest 1.97%.
I can practically hear the high yield investors rolling their eyes at a sub two percent yield.
Oh, I know. On the surface, it sounds incredibly boring. But let's look at the actual business metrics
here. J&J boasts a 64 year uninterrupted streak of dividend increases. 64 years. That's wild.
And more importantly, it generates an astonishing $21 billion in annual free cash flow.
It operates with a pristine AAA rated balance sheet. That's a rating higher than the US
government itself, by the way. Wow. And over the past year, it delivered a massive 54% total return.
So, I mean, the takeaway here is pretty clear. The frequency of payment, the psychological comfort of
just getting that monthly cash does not equal structural safety. And it absolutely does not equal
total return. Exactly. If you're looking at a 15 to 20 year retirement horizon, J&J is the true
compounding engine. It has the balance sheet strength and the cash flow generation to just weather
a 4% interest rate environment indefinitely without sweating. Whereas realty income,
despite that very appealing monthly payout schedule, it carries significant interest rate risk
and tenant credit risk that investors are arguably not being adequately compensated for right now.
Okay, but that brings up a critical logistical question, though. Because if an investor accepts
a prioritizing total compounding return over a high starting yield is the smarter play,
how does a retiree actually generate their necessary cash flow?
It's a great question. Do they just sell their shares of growth companies or do they rely on
these new option income ETFs? Well, let's start with the traditional academic approach, right?
Generating cash by strategically selling shares of a growing asset.
There is this deeply revealing back test in the sources of the strategy, starting in January
2022, which is notable because that was right before a major painful bear market. Exactly. It's
the perfect stress test. The simulation tracked an investor withdrawing exactly 6% per year for
living expenses. And the results of that simulation really push back against conventional wisdom.
If you held the broad growth oriented S&P 500 ETF ticker SPY and simply sold off shares periodically
to generate your 6% cash need, you actually ended up with more total wealth than if you relied on
the dividend focused Schwab US dividend equity ETF ticker SCHD. Yeah, and this is why total return
is the only metric that ultimately matters. Even though SCHD was paying out a growing reliable
dividend stream, SPY's capital appreciation was just structurally stronger. The underlying
companies in the S&P 500 were growing their intrinsic value faster than the dividend companies
were distributing cash. So even after selling off shares of SPY and physically reducing your total
share count, your remaining pile of money was larger. But there's a catch there. Right, there is a
caveat. If you stretch that exact same simulation out over a 26-year timeline, SCHD's compounding
dividend growth rate eventually hits an inflection point. It overtakes the pure growth strategy
and wins out in the end. Okay, but let's be honest about human psychology for a second.
Selling shares physically hurts. Oh, it's tough. Watching your share count drop month after month
during a bear market, it feels like you are cannibalizing your own life savings. And this psychological
friction is exactly why billions of dollars are flooding into covered call ETFs right now.
Yes. Specifically funds like SPY and QQQI. And this is where we really have to get into the weeds on
taxes. Because Return of Capital, which we just identified as a massive red flag for that leveraged
fund, PFFA, it is actually the core feature of these covered call funds. It's basically their super
power. And it is arguably one of the most misunderstood accounting mechanics in the entire retail
market. SPYI and QQQI generate their massive distributions by selling options. But here is the
critical distinction. They don't sell options on the ETF itself. They sell Section 1256 index options
directly on the S&P 500 and the NASDAQ 100 indices. Okay, Section 1256. Let's unpack the mechanics of that.
Why does this specific type of option completely change the tax profile? Well, under the US tax code,
Section 1256 contracts receive highly specific treatment. But beyond the standard 6040 capital
game split, these specific funds utilize this brilliantly complex accounting mechanism regarding
how they handle losses. Okay, how does that work? When the fund closes an option position at a capital
loss, it banks that loss on its books. Later, when it successfully collects option premium, which is
technically a capital game, it aggressively uses those banked losses to offset the new gains.
This accounting effectively pushes the funds official earnings and profits down towards zero
for tax reporting purposes. And if they have zero official earnings and profits, the IRS dictates
that the cash they are physically handing to the investor literally cannot be classified as a
taxable dividend. Precisely. Under Section 3, one of the tax code, if a distribution exceeds the funds
earnings and profits, it must be reclassified as a return of capital. And to put real numbers to
this, in 2024, an astonishing 93.91 percent of SPYI's distribution was classified as return of
capital. Wow. 93 percent, which means it doesn't even go on your tax return as income. It doesn't
bump you into a higher tax bracket. It doesn't trigger IRMA surcharges on your Medicare premiums,
and it doesn't cause your social security benefits to become taxable. The only thing it does is lower
your cost basis in the investment itself. Exactly. You receive the cash flow today to pay your bills,
and it is completely tax-free in the present moment. You are essentially just deferring the tax
liability into the future. Wait, let me challenge the long-term reality of that, though, because if I'm
retired and I just spend those monthly distributions instead of reinvesting them, my cost basis is
dropping every single month. Mathematically, in about nine years, my cost basis is going to hit absolute
zero. Right. What happens in year 10, the tax deferral runs out, and don't I suddenly get slammed
with long-term capital gains taxes on every single check going forward? Technically, yes.
Once your basis hits zero, any further return of capital distributions are taxed as long-term
capital gains. But let's look at the actual tax brackets for a married couple filing jointly
in 2026. The 0 percent long-term capital gains bracket goes up to nearly $99,000 of taxable income.
Wow. Okay. So if this portfolio is your primary source of income, and you manage your other
taxable withdrawal carefully, your actual tax bill could still literally remain at zero,
even after your basis is fully depleted. That is a staggering realization for retirement planning,
and there's an even more powerful mechanism if the investor holds the fund for their entire life
isn't there. Oh yeah. It is entirely legal and explicitly written into section 1014 of the tax
code. If you hold the fund in a taxable account until you pass away, your errors receive what is
called a step-up in basis. This step-up. Right. The cost basis of the asset is instantly reset to
the fair market value on the date of your death. Every single dollar return of capital you took
tax for you along the way, all that deferred tax liability. It's entirely erased. The slate is wiped
totally clean. So if we look closely at SPYI and QQQQY, they aren't just high yield instruments.
For retiree, they are precision tax planning tools. As long as the fund is actually generating
real cash from the options in the net asset value, the actual underlying principle of the fund
isn't slowly eroding away. This is an incredibly powerful strategy for a standard taxable brokerage
account. But that last point you made is vital. This complex tax magic relies entirely on the account
being taxable. If you hold these funds inside an IRA or a 401k, the strategy is completely useless.
Why that? Because everything that comes out of a traditional tax sheltered retirement account
is taxed as ordinary income upon withdrawal, regardless of how it was generated inside the account.
The return of capital mechanics just don't apply. Which begs the question. If all those tax tricks
are totally nullified inside an IRA, where are retirees actually turning to generate high yield
inside those sheltered accounts? And more importantly, which supposedly safe blue chip stocks
are secretly falling apart underneath those high yields? Well, with traditional fixed income
offering around four or five percent, we are seeing a massive wave of retirees loading up their
IRAs with ultra high yield targets, specifically business development companies or BDCs. Right.
These are firms that act as shadow banks, basically lending money to mid-sized private businesses.
A standout example is Eris Capital, ticker ARCC. It yields nearly 10 percent and operates as the
premier player in the BDC space. Yeah, and we're also seeing a lot of capital flow into energy
infrastructure, like MPLX, which yields 7.15 percent, and it's heavily backed by marathon petroleum's
vast pipeline network. Then there is the commercial real estate debt side, with Starwood property
trust, ticker STWD. It yields an eye-watering 12.3 percent. And what makes Starwood really unique is
that it hasn't cut its dividends since its inception in 2009, meaning it has successfully navigated
multiple severe commercial real estate cycles without reducing its payout. That's impressive.
It is. And on the more traditional equity side, you have universal corporation, ticker UVMV,
yielding 7.36 percent, while boasting over 50 consecutive years of dividend increases.
So those are the heavy hitters attracting the yield cheaters right now. But looking across the
broader market provides a massive reality check. We are currently seeing blue chip household
named dividend stocks sitting at complete 52-week lows. It proves our central throughline perfectly.
A high yield is not a discount if the underlying business is actively eroding beneath you.
Exactly. The operational numbers on some of these legacy companies are highly concerning right now.
Take lows, ticker LOW. The stock is suffering heavily because 5 percent mortgage rates have
essentially frozen the housing market. Yeah, nobody wants to move. Right. When people can't afford to move,
housing turnover plummets, and those expensive DIY renovations just grind to a halt,
the macroeconomic environment is directly suffocating their revenue model.
And look at McDonald's ticker MCD. Their global sales grew by only 1.3 percent in the most recent quarter.
If inflation is running higher than 1.3 percent, that means in real inflation adjusted terms,
McDonald's sales are actively shrinking. They are losing ground. Yeah. Even on the real estate side,
VICI properties, ticker VICI, which owns the land under major Las Vegas casinos,
yields 7.4 percent. Okay. But they just had to purposefully lower their dividend growth rate
to retain cash. Simply because refinancing their debt in a 4 percent world is vastly more expensive.
But, you know, the most alarming case study of value destruction right now is Pepsi, ticker PEP.
Oh, man, underlying financials for Pepsi are staggering when you really dig into them.
They really are. Currently, Pepsi has a 99.5 percent free cash flow payout ratio.
Only 99.5? Yes. That metric means virtually every single dollar of actual cash
the business generates from selling snacks and sodas is going straight out the door to pay the
dividend. There is zero margin for error. But wait, if they are paying out 99.5 percent of
their cash as a dividend, how are they also funding their massive share buyback programs?
They have to be bridging that gap somehow. Are they taking on debt to fund this?
Yes. That is exactly what is happening. They are spending roughly $8.9 billion annually on
dividends and buybacks combined, which is significantly more than the business actually generates
in free cash flow. So to bridge that multi-billion dollar shortfall, they are actively weakening
their balance sheet. They are borrowing money at today's higher interest rates,
strictly to fund shareholder returns. It's the equivalent of taking out a high interest
loan just to pay for your neighborhood block party. I mean, sure, everyone on the street is
thrilled about the free hot dogs, those are the dividends. But the financial foundation of your
actual household is completely cracking beneath the surface. Eventually, the bank is going to call
that loan. And yet, because of behavioral finance and psychological anchoring, investors look at
Pepsi's 50-plus-year history of consecutive dividend increases and they automatically assume the
stock is inherently safe. They see the yield is slightly higher than its historical average,
and they just blindly assume it's a bargain, which brings us right back to the central theme of
today's deep dive. We have covered a massive amount of ground today. We started by dissecting
the leverage trap of PFFA, demonstrating how a shiny 10% yield gets quietly eaten alive
by floating borrowing costs tied directly to the Fed's newly permanent 4% rate.
Right. And we examine the structural risks of the reap portfolio, exposing how realty
income's massive debt load and, you know, lower tier tenant base create an illusion of monthly safety,
especially when you compare it to the triple a rated compound and cashflow machine that is Johnson
and Johnson. We unlocked the complex tax mechanics of QQQI and SPYI, detailing how section 1256
options in return to capital can legally drop a retiree's tax bill to zero, particularly
when paired with a step up and basis at death. And we exposed the 52-week low trap,
highlighting how legacy giants, like Pepsi, are actively degrading their own balance sheets,
borrowing money just to keep up appearances, and fund payouts they simply haven't genuinely earned.
Through every single one of these examples, the through line remains undeniable.
Yield is not total return. In a macroeconomic environment where the Federal Reserve is firmly
holding rates at roughly 4% through 2027, you just cannot afford to take a stated yield at
face value. You must look under the hood. You have to determine if a distribution is actually
being earned by the underlying operational cash flow of the business, or if it is just your own
principle being handed back to you to manufacture the illusion of yield. Realizing that distinction
completely changes how you look at the construction of a portfolio. It really forces a necessary evolution
in how we invest. And I want to leave you with a final thought to ponder, something that builds
on the corporate psychology we just discussed with Pepsi. Because for decades the market has relied on
historical streaks like 50 consecutive years of dividend growth as the ultimate indicator of safety.
We treat the dividend kings as untouchable royalty. Right. I mean, joining that list is basically
the ultimate badge of honor for a publicly traded company. It is. But in a structurally changed
economy, an economy with permanently higher borrowing costs, what if the very act of maintaining
that 50-year streak is exactly what eventually bankrupts these legacy companies? Is the relentless
pursuit of the streak where executives are terrified of the stock collapsing if they cut the dividend?
So they willingly take on toxic debt to pay a dividend. They didn't earn actively destroying
a long-term shareholder value. Next time you see a giant red 50% off sticker on a 52-week low
dividend stock. I want you to remember this conversation. Keep questioning the underlying numbers.
Look under the hood at the balance sheet and whatever you do, don't mistake a flashing
distress signal for a discount. Thanks for joining us on this deep dive. See you next time.