Ep. 95: Honest Math on Income — Covered Dividends, Real Yields, and the 20% Trap

Welcome to The Deep Dive, imagine buying a stock that pays you a massive 20% dividend.
Yeah, which sounds like an absolute dream scenario.
Exactly. But then you realize months later that, well, the company isn't actually paying you
out of its profits. Right. They're just handing you your own money back.
Literally piece by piece. Yeah. And charging you a management fee to do it.
It's brutal. It really is. And you, the listener,
you actually sent us a massive stack of sources today to look into this.
We've got everything from Deep Dive equity research reports to some seriously dense ETF
prospectuses. Oh yeah, the prospectuses were a heavy read.
For real, but you sent them because you're trying to navigate this high yield minefield.
And it truly is a minefield out there right now. I mean,
we're looking at a financial landscape where a high percentage yield flashing green on your screen
can look, you know, incredibly healthy, right? But internally, the company's
financials are essentially on life support. Yeah. So that is the core problem we're tackling today.
We're running all your sources through a filter that we call honest math.
I love that phrase so much. Honest math. It fits perfectly.
It does because we aren't just looking at the shiny yield percentage.
We are looking under the hood. Our mission today is to figure out if these
dividends are like actually covered by real earnings and free cash flow.
Exactly. Is the yield real or is it a trap? Right. So here is the roadmap for today's Deep Dive.
We are going to walk the entire income spectrum. It's a wide spectrum too.
Oh, totally. We'll look at the bedrock of traditional dividend growth, hunt for bargains
and real estate, explore how a 10% yield could surprisingly be safe, which is a fun one.
Yeah, that one blew my mind. Then we'll lay out the ultimate retiree foundation
and finally we're going to stare directly into the sun at some wild 20% target distribution
funds. So we should probably start where the math is supposedly the easiest to verify, right?
Yeah, the traditional dividend growth stalwarts. Exactly. Looking at the equity research you provided,
the focus is squarely on big pharma, specifically three household names.
We're talking Abby Johnson and Johnson and Pfizer.
Okay, let's use an analogy here because analyzing these corporate dividends always reminds
me of evaluating a car's performance. Oh, I like this going.
So the dividend yield, that percentage you see quoted everywhere, that is your top speed.
But the free cash flow, that is the actual engine. If the engine is too small,
you can't maintain that top speed without eventually just blowing out the cylinders.
That is a perfect way to visualize the causality there because I mean, a company can only pay out cash
that it actually physically generates. Right. So let's look at Abby ticker ABBBBBBB and Johnson and Johnson
ticker J and J. Both of these engines are running pristine. Yeah, they really are.
Abby is trading around $251.06, offering a 2.68% yield. Okay.
And Johnson and Johnson are sitting at $253.73, with a 2.06% yield.
And J and J is like a legendary dividend king, right?
Over six decades of consecutive raises. Yep, they are the gold standard.
But the honest math metric we actually care about is the payout ratio. Exactly.
So for Abby, the dividend consumes only 59% of their free cash flow. And for J and J, it's 60%.
Which means they have a massive 40% cushion. Yeah, that's huge.
Think about what a company can do with 40% of its cash just sitting there. I mean,
they can reinvest in new drug trials, buy back their own stock, pay down debt, or just survive a
recession. Exactly. Navigate a brutal recession without ever once having to threaten your
dividend income. It is the literal definition of sustainable. But let's pan over to Pfizer,
ticker PFE. Oh boy, here we go. Yeah. It's trading way down at $23.88, but it boasts this massive
7.20% yield. Right. Now, if you're just blindly yield chasing, you look at J and J's 2% and Pfizer's
7.2% and you think you've found an absolute steal. And that assumption is the ultimate trap.
To push your car analogy further, if the dividend is the top speed, Pfizer is currently flying
down the highway at 100 miles an hour, but the engine is just sputtering out. Oh man.
The honest math red flag is buried deep in their cash flow statement. Over the past 12 months,
Pfizer's dividend payments have actually exceeded both its earnings per share and its free cash flow.
Wait, I need to make sure I'm hearing that correctly. Yeah. They're paying out more cash to share
holders than the business is physically generating. That is exactly what the data shows. Wow.
When a payout ratio exceeds 100%, that extra money has to come from somewhere, right? I mean,
yeah, it doesn't just appear. Exactly. They either have to borrow money to pay the dividend or they have
to siphon cash out of their existing reserves, which is not sustainable. Not at all. Pfizer's dealing with
a massive post pandemic revenue cliff. You know, the COVID vaccine money dried up and they're facing
major patent explorations on their older drugs. So unless they suddenly invent a miracle drug,
like those GLP1 weight loss drugs we keep hearing about. All right. The new gold rush. Yeah.
Unless they do that, that massive yield is just a mirage. They are just burning through the gas tank
to keep the speedometer up and eventually the tank runs dry. Yep. Unless there are new oncology pipeline
or a competitive GLP1 drug prints billions in fresh cash very soon, that 7.2 zero percent dividend
is highly, highly vulnerable to a cut, which would crush the stock price too. Exactly. That means a
lower yield from JNJ is mathematically worth more than a higher yield from Pfizer because the JNJ yield
is actually rooted in reality. Okay. So if Pfizer shows us the danger of a high yield that is covered,
where do we go to find a yield that is bulletproof even if it's a bit lower? That leads us directly
into the real estate sector. Right. The sources highlight a really interesting piece on a net lease
rate, a real estate investment trust called Postal Realty Trust ticker PSTL. Yeah. Right now,
PSTL is sitting at a 3.96 percent yield with a share price of $24.72. Okay. I'm going to stop you
right there and play devil's advocate for the listener. Go for it. Why on earth would I look at PSTL's
3.96 percent yield when the absolute giants in this space like Realty Income ticker O pays 5.2 percent.
Right. And NREA pays 5.1 percent. I mean, I'm looking at a tiny 868 million dollar microcap
company and taking a lower yield than the fortress level industry leaders. You have to make that
math make sense for me. And that pushback is entirely fair. Yeah. It really comes down to understanding
two crucial concepts in real estate. The AFO payout ratio and the preservation of net asset value
or NIV. Okay. Let's start with AFO. Sure. Because I see AFO mentioned constantly in these real estate
research notes, adjusted funds from operations. But like real estate always has its own complex language.
What does that actually mean for the safety of the dividend? Think of AFO is the real estate world's
strict version of free cash flow. Okay. It measures the actual hard cash generated by the properties
after accounting for all the money they have to spend on maintenance, leasing commissions,
you know, property upgrades. So it's the real bottom line. Yes. It's the cash that is truly
available to hand over to you, the shareholder. Got it. So PSTL's 2026 AFO guidance is around a
dollar 40 to a dollar 42 per share. Okay. But their dividend is only 98 cents. Oh wow. So they are
only paying out about 69 percent of the cash they generate. Precisely. They have a huge safety
cushion. And honestly, it's backed by rent checks from a federal tenant, the United States Postal
Services. Right. Pretty reliable tenant. Very. But to answer your question about why we are looking at
this micro cap instead of the 5 percent giants, we have to look at how PSTL's total return was achieved
over time. Total return being the actual price appreciation of the stock plus the dividends you
reinvested. Yes. Since its inception, PSTL's total return is a staggering positive 116.65 percent.
That's massive. It is. But the crucial data point here is that the price return alone is
up 46.27 percent. Wait, just the price. Just the price. This means there has been zero NAV
erosion. The value of their underlying properties and their share price went up. Right.
The 3.96 percent income you are getting is being added on top of a growing share price.
Ah, okay. I get it. You aren't cannibalizing the value of your own house just to pay the mortgage.
You are getting paid while the house appreciates. Exactly. That is the honest math of real estate.
However, the sources do include a massive warning label here. Uh oh. Yeah. PSTL's recent price
doubling going from like $13 a share up to nearly 25. That was a massive re-rating. What does that
mean? It was a one-time market correction as investors realized the stock was undervalued. You cannot
extrapolate that explosive past growth into the future. Okay. So for you listening, the choices
basically a philosophical one. Very much so. Do you want a 5.22 percent yield today from the massive
sprawling scale of real-t income? Or do you want a hyper-covered 3.96 percent yield from a tiny
company like PSTL that has a ton of room for future dividend raises and historically zero capital
erosion? Which brings up an incredibly natural dilemma for investors. Yeah. What if you don't want to
make that compromise? Right. What if you want a massive 10 percent yield today?
But you absolutely refuse to step into the Pfizer trap. Is it even possible to get 10 percent
without destroying your principal over time? I know exactly what you're thinking at home.
We just spent 10 minutes telling you a 7 percent yield at Pfizer was toxic and now we are going to
explore if a 10.5 percent yield is safe. It sounds totally contradictory. It feels like removing the
goalposts. But let's look at the business development company space or BDCs. The sources highlight
the heavy hitter in this space. Heirs capital, ticker, ARCC. Right. ARCC is currently trading around
$18.50 and yielding a staggering 10.5 percent. Okay. Let's break down the mechanics here. Before we
even talk about safety, what exactly is a BDC and how do they generate enough cash to pay 10.5 percent
in the first place? Think of the BDC as an alternative bank. Traditional banks often ignore mid-size
private companies because those loans are too complex or slightly riskier. BDCs step in and lend
money to those middle-market businesses. They make their money on the spread. The spread between
what they borrow and what they charge. Exactly. They borrow money at a lower interest rate and they'd
lend it out to these private companies and it's significantly higher usually floating interest rate.
And by law, they have to pass almost all of those profits directly back to shareholders as dividends.
But the macroeconomic environment is getting kind of rocky. It is. I mean, ARCCs peers, like Blue
Owl and Golub Capital, they've recently cut their dividends because interest rates are falling,
which shrinks that profit spread, right? So how does ARCC survive that? ARCC is the exception to the
rule and it all comes down to the honest math of their specific balance sheet. The first thing we
verify is the dividend covered by operating profits. ARCC's core earnings per share in the first quarter
came in at 47 cents. When you factor in their net-realized games, that fully covers their 48 cent
quarterly dividend. Covering it by a single penny feels uncomfortably tight, though, doesn't it?
It would be if that were the whole story. But ARCC has two massive safety nets that most of their
competitors simply don't have. Okay, what's the first one? First is something called spillover
income. Spillover income, like a rainy day vault? Basically, yes. In years where ARCC earned vastly
more than they paid out, they retained some of that cash. Oh, nice. Right now, ARCC has a dollar 38
per share in spillover income just sitting on the books. Let me do the math on that. If the quarterly
dividend is 48 cents, having a dollar 38 in reserve means they have nearly three full quarters
of dividend payouts locked in a vault. Exactly. So even if they're borrower companies struggle
and earnings dip temporarily, they don't have to cut the dividend. They just open the vault.
That is a phenomenal layer of safety. And the second safety net is their leverage headroom.
Okay. By law, BDCs have strict regulatory limits on how much debt they can take on to fund their
lending. ARCC targets a debt equity ratio of 1.2 five times. Right. But right now, they're sitting
at just 1.10 times. Meaning they are underbarrowed compared to what their own internal limits allow.
Exactly. So if things get ugly in the economy, they have a massive cushion to absorb the shock
without breaching their covenants or being forced to sell off assets at like fire sale prices.
Yep. Add to that the fact that they're non accruals, which are basically loans to companies that
have stopped paying their interest, sit at just 2.1% at cost. Oh wow. Yeah. The historical average for
the BDC industry is closer to 4%. Their loan portfolio is remarkably healthy. So the takeaway for
the listener is that a 10.5% yield isn't inherently a trap. Right. If the underlying portfolio of loans
is healthy, the company is under leveraged. And you have almost a year of cash and reserve.
Well, that 10.5% is mathematically honest. It is. But realistically, you cannot build a responsible
retirement portfolio out of nothing but 10% yielding alternative banks in microcap post office reads.
Yeah. That would be terrifying. I need a foundation. Let's talk about building that bedrock. If you
are an income investor, you need a core ETF and exchange traded fund to anchor the whole operation.
Absolutely. And the sources give us a fantastic showdown between two heavyweights here.
The classic. Yeah. In one corner, Charles Schwab's US dividend equity ETF ticker SCHD. It yields 3.25%
with a tiny 0.06% management fee. Great. In the other corner, Van Guards dividend appreciation ETF ticker
VIG. It yields 1.47% with an even 10 year 0.04% fee. Right. Now looking at the raw numbers, SCHD pays
more than double the yield of VIG. Why are the sources even framing this as a debate?
Because we have to separate total return from income generation. Okay. Explain that.
If you are a young listener and you just want pure explosive capital appreciation,
the honest math says neither of these is your best bet. Right. Because of growth stocks.
Exactly. The sources are clear that a pure growth fund like Van Guards VIG will completely
crush dividend ETFs in sheer price growth over 10 year period. Because growth companies like Amazon
or Metta reinvest all their cash into expanding and building new tech rather than bleeding it out
to shareholders as a dividend. Exactly. But if you are a retiree or someone who needs
actual spendable cash flow to live on without being forced to sell your shares, you need an income
engine. Yeah. And this is where the genius of SCHD shines through a concept called yield on cost.
Oh, let's really unpack yield on cost because I think this is where the magic happens for long-term
investors. It really is. It works like this. Imagine you bought SCHD 10 years ago. Okay. Today,
the fund yields 3.25%. Yeah. But SCHD doesn't just pay static dividends. It specifically filters for
companies that have a history of aggressively growing their dividends year after year. Right.
dividend growers. Over the last decade, the 100 companies inside SCHD have raised their payout so
consistently that if you measure today's dividend payment against the original price you paid 10 years
ago, your effective yield on that initial investment is now 7.58%. That is wild. You bought the fund
expecting a modest 3% cash flow. But because the underlying companies grew their businesses and
hiked their payouts, you are now getting nearly 8% on your original money. And you didn't have to
lift a finger. And crucially, your underlying principle grew alongside it. Right. That is why the
research concludes that SCHD is the premier income now and income later bucket. What about VIG?
VIG is a fantastic fund. It focuses heavily on companies with very long histories of dividend
growth. And it actually has slightly better recent total returns. Okay. But starting with a
meager 1.47% yield means it takes decades to reach the sheer cash flow volume that SCHD gives you
much sooner. So for the absolute core of your portfolio, SCHD gives you immediate meaningful cash flow
today to pay the bills and dividend growth tomorrow that outpaces inflation. It is the ultimate
expression of the honest math of compounding. But let's be real. Human nature plays a huge role
in investing. Unfortunately, yes. What if you are impatient? What if a 3% yield from SCHD or even a 10%
yield from Eris capital simply isn't enough to fund your lifestyle? Then you start looking for
shortcuts. Exactly. When greed kicks in, people want maximum immediate cash flow right this second.
And that brings us to the final, most dangerous frontier we are covering today. High income covered
call ETFs. Yeah. This is where the honest math gets incredibly brutal and where the most investors
get burned. The perspectives as we are looking at highlight a relatively new player in the space.
The Neos boosted NASDAQ 100 high income ETF ticker XQQI. Right. This fund has a jaw dropping target
annualized distribution of 19 to 23%. It's just an insane number to look at. Right. Recent payouts have
been around 92 cents a share paying out every single month, but targeting 23%. Going back to my car
analogy, this sounds like strapping a nitrous oxide booster to a Honda Civic. Great visual. Sure,
you go incredibly fast for a few seconds, but aren't you going to completely blow out the engine?
The documentation completely validates your fear. To generate a 20 plus percent yield,
XQQI isn't just relying on the meager dividends of the underlying tech stocks in the NASDAQ 100.
Because tech stocks don't pay 20%. Exactly. They are utilizing complex option strategies.
Specifically, they use up to 150% notional exposure. So they are using leverage, borrowed money
or derivative exposure to artificially amplify the returns? Yes. And the problem with leverage is
that it is a ruthless double edged sword. How so? It magnifies your gains when the NASDAQ is having
a bull run, but it severely magnifies your losses in a down market. If the underlying index drops
10%, a fund with 150% exposure might drop 15% or more. Okay, so they have leverage amplifying
the risk, but how are they actually generating that massive monthly cash payout?
They combine that leverage with a covered call strategy. They sell index options which are treated
as Section 1256 contracts. Let me stop you there. Section 1256 covered calls. Break down the
mechanics for us. How does selling a call option actually work in this context?
By selling a call option, the fund is selling someone else the right to buy their best performing
stocks at a preset price in the future. In exchange for granting that right, the fund receives a lump
sum of cash today which is called a premium. That premium is what they pass on to you as the massive
dividend. Also, thanks to a tax rule called Section 1256, those index options actually give investors a
slight break on capital gains taxes. Sounds great so far. Cash today, tax breaks, what's the catch?
The catch is that by selling that option, you place a hard cap on your upside.
Oh. Yeah. If a stock like Nvidia suddenly surges 30% on good earnings,
the fund is forced to sell it to the options buyer at that lower preset price.
Oh wow. You get the cash premium today, but you completely forfeit the massive growth tomorrow.
So you cap your gains, but because of the leverage, you still take all the amplified downside risk.
Exactly. That sounds like a terrible trade. And here is the most critical honest
math takeaway of the entire deep dive. You have to look at the fund's 19a1 notices.
What are those? These are the boring tax documents that legally force the fund to tell you where the
distribution money is actually coming from. Okay. And what did they say for XQQI?
For XQQI is a recent 92 cent monthly distributions. Roughly 100% of it has been classified as
return of capital or ROC. Okay. Um, return of capital sounds nice on the surface.
It sounds like a refund. It is a refund. It is a refund of your own money.
Wait, what? When a fund pays you return of capital, they are paying you from investment profits.
They are paying you from corporate dividends. So where is it coming from?
They are literally liquidating a piece of your original investment, your principal and handing it back to you.
Wow. Let me walk through an example to make sure I grasp the gravity of this.
Please do. You put a $100 into this fund. Over the year, they give you $20 back in these monthly
distributions and they proudly tell you that you earned a 20% yield. But in reality, you just have
$80 left in the fund, $20 in your pocket, and you paid them a management fee to move your money from
one pocket to the other. That is exactly what is happening under the hood. Now, fund managers will
argue that ROC has a tax benefit. How is losing money a tax benefit? Well, it isn't taxed in
immediately as income. It lowers your cost basis, which differs taxes until you eventually sell
your shares. Okay, I guess. And they argue that their active trading strategy aims to regenerate that
lost principal over time. Do they actually do that though? The historical data on these ultra high yield
covered call funds is stark. Near certain NAV erosion, you know, those slow shrinking of your principal
is the price you pay for that nitrous boost. So bringing this all together for you listening,
we have covered a massive spectrum of the income universe today. We really have. We started with
the absolute bedrock, Charles Schwab's SCHD offering a steadily growing 3.25% yield backed by 100 cash
flowing, corporate giants. Then we looked at the real estate reality check with PSTL, showing us how a
hyper-covered 3.96% yield with zero capital erosion is mathematically superior to just blindly chasing a
5% yield. Absolutely. We saw that even a massive 10.5% yield can be mathematically honest if it's
backed by the spillover income bolts and low leverage of a BDC like air is capital. And on the flip side,
we expose the traps. We did. We looked at Pfizer's 7.2% yield that currently outstrips its ability to
generate free cash flow, turning a massive legacy company into a potential yield trap. They're right.
And finally, we dissected XQQI's leverage 20% distribution that caps your upside, magnifies your
downside and simply hands you your own money back to skyse's income. The through line across all these
sources is always the same. Honest math means ignoring the flashy percentage on the screen and knowing
exactly what you are trading away in exchange for your yield. Exactly. Are you trading away future growth?
Are you trading away safety? Or are you like we just saw trading away your own principle?
If you read the cash flow statements, verify the payout ratios and check the tax documents for
return of capital, you can actually build an income stream that survives both bull and bear markets.
We all spend so much time optimizing our portfolios, chasing the highest possible monthly payout to
feel secure. But I want to leave you with a final lingering question to ponder on your own.
It's a good one. When you buy into one of these ultra high yield frontier funds and the honest
math reviews that your 20% yield is just slowly braining your original investment,
ask yourself, are you actually investing? Or are you just slowly liquidating your own wealth and
paying a management fee to someone else to do it for you? Thank you for joining us on this deep dive.