Retired? You crave income. A long Treasury bond pays 5%. Not enough to cover the bills. A Treasury fund shows up with a 10% yield. Tempting, isn’t it?
You are now entering the world of yield fantasies. Wall Street is happy to feed these fantasies, and to soak you in the process.
The true yield of an investment is what it can throw off, indefinitely, without any erosion of capital. The fruit, not the tree. It is only so much. There is no way to make it bigger. If you spend more than that, you are dipping into capital.
Evidence that people don’t understand this: the proliferation of funds with “income” in the name and double-digit payouts. Look closely at these things and you see that, one way or another, they are in effect handing investors their own capital back.
Herewith is a representative sample of funds with puffed-up payouts. For each there will be an explanation of the mechanics and a recommendation for an alternative course of action. Also below, seven stocks and preferreds with seemingly unsustainably high dividend payouts.
1. iShares TLT Premium Income +
This exchange-traded fund owns a collection of Treasuries and then writes call options against them. Premiums collected on the options are dished out, alongside bond coupons, in monthly dividend checks. Over the past year, Morningstar reports, those payouts have summed to 10% of the share price. That’s double the yield on the bonds.
Option premiums are income, of a sort. But you are deluding yourself to think this is the kind of income you can safely spend. Bond prices fluctuate. When prices go down, the holder of a bond against which a call option has been written suffers that same price decline. When prices recover, the option writer does not recover; his bonds get called away.
There are good years to be writing calls and there are bad years, but a chronic covered-call investor is destined to see his capital erode. The expected erosion is equal to the premiums pocketed. That’s how markets work.
Several other bond ETFs have cropped up using this premium-income strategy. History is repeating.
Forty years ago there was an outpouring of Treasury funds inflating their reported yields by selling options. The Securities & Exchange Commission cracked down with a rule requiring the disclosure of a yield number that excludes option income. The enhanced-yield gimmickry fell into disrepute and went away for a long while. Now it seems to be coming back. Investors have short memories, and they don’t read the fine print about yields.
Recommended alternative: Buy the Vanguard Long-Term Treasury Index ETF. Its 5% yield entails no gimmicks.
2 Simplify Barrier Income
This $25 ETF pays a steady 25-cent monthly dividend. That’s a 12% annual payout. Alluring.
Where does the money come from? Selling options. The fund sells stock market crash insurance to other people. If stocks don’t crash you can pocket the income. But if they do crash, a big chunk of your capital is carted off to make the insurance buyers whole.
The balance sheet is a bit complicated. It mixes cash with a laddered collection of put options sold short, each maturing in one year. The reference point for each put is the worst-performing of three different stock indexes (big cap, small cap, growth). If the worst is down more than 30%, the fund absorbs the full loss. If the worst is either down less than 30% or up, the fund doesn’t owe anything to the option buyer. There’s also a provision calling for an option to be terminated early (with the fund keeping the whole premium) if stocks go up in a certain pattern.
The resulting portfolio has substantial stock-market risk, but less than you get in a stock index fund. The risk is comparable to that in a balanced fund blending stocks and bonds.
The fund has led a charmed life since it opened up a little over a year ago. It has hauled in $400 million of investor capital and witnessed no crashes.
I take it as given that the fund gets a good price for the options. Simplify Asset Management, profiled here, is an astute and creative manager of risk. Most of its products go the other way—that is, toward reducing risk. The Simplify Interest Rate Hedge ETF, for example, takes the edge off a bond portfolio by going up in value when bond prices go down; this fund has delivered an extraordinary 24% annual return over the past five years.
What’s not to like with Barrier Income? That word “income” in the name.
Imagine that you participate in the underwriting of a policy that insures an oil platform against hurricanes. Your share of the premium is $30,000 a year. In a hurricane, which hits once in 50 years, you owe $1 million.
Years go by without a hurricane. Is your income $30,000 a year? No. It’s $10,000. It’s the premium minus your expected loss.
Simplify is candid about the risk in Barrier Income. It’s not candid about what that 25-cent dividend represents. It’s not income.
Alternative: Buy the Vanguard Balanced Index Fund. If you need cash, sell a few shares.
3. Neos Bitcoin High Income
This scheme to make cryptocurrency into an income-producing retirement asset is a farce. Bitcoin doesn’t yield anything.
The fund (and numerous others like it) uses the predictable covered-call strategy to manufacture income. If crypto ever recovers from its recent bear market, call writers will suffer the predictable whipsawing effect of a volatile market.
Alternative: For income, own a bond fund. For speculation, buy a low-cost bitcoin fund (like iShares Bitcoin Trust).
4. Nuveen Global High Income
This leveraged closed-end junk bond fund lends to both iffy corporations like Goodyear Tire and sketchy countries like Argentina. It is well managed; since it opened in 2014 it has comfortably beaten Vanguard’s corporate junk fund. Why is it cited in this chronicle of yield puffery? Simply to illustrate a point about junk: The true yield is less than meets the eye.
The Nuveen fund is paying a monthly dividend that annualizes to 9.1% of its net asset value. But the portfolio’s annual long-term return is only 5.2%. This fund, like all junk funds, pays out more than it can sustainably return.
Junk portfolios undergo a downward ratcheting of principal. That’s because good bonds—bonds whose issuers experience improving prospects or a decline in market interest rates—get called in early. The fund is left with a concentration of not so good bonds. Since 2014 the Nuveen fund’s net assets per share have shriveled from $20 to $13.58.
Don’t be naïve about how much you can spend from a fixed-income investment. From the reported yield of a junk fund, subtract two to four percentage points for principal erosion. That leaves 6% or so for the Nuveen fund. While you’re at it, subtract another three points for inflation. What’s left is the sustainable yield. If you want to maintain your standard of living, plan on pulling only 3% a year from a junk bond portfolio.
Alternative: Buy a Treasury Inflation Protected Security due in 2056. Its real yield was recently 3%. That’s money you can spend. No guesswork needed about defaults or inflation.
5. YieldMax TSLA Option Income Strategy
This fund, and many others of its ilk, are aimed at investors who yearn for the excitement of high-growth, low-yielding stocks but crave cash payouts. It uses a complicated option strategy (“call spreads”) to create income. Alas, this eats into principal.
Last year, Morningstar reports, the YieldMax Tesla fund dished out $34 in dividends as its share price went down from $71 to $38. More than a fourth of the manufactured payout came out as high-taxed ordinary income.
Alternative: If you want some income, put half your Tesla money in the stock. Put the rest in Treasury bills.
6. Amplify CEF High Income
This fund of funds owns shares of other investment companies, favoring ones trading at a discount to net assets. There’s a blend of stock and bond closed-end funds in the Amplify product. Some of these pay nice dividends, which Amplify passes along, but there evidently isn’t enough cash coming in to satisfy shareholders. More than half of Amplify CEF’s payout last year was a “return of capital,” meaning that shareholders had principal returned to them.
You don’t need to pay a fund a stiff fee to return your own capital. You can do that all by yourself. Liquidate something.
Fees? Hoo-boy. Amplify reports that its expense ratio, including fees charged by the underlying funds, comes to 3.23%. I suspect that this number includes, per a stupid SEC rule, interest costs, but even if you backed out the interest you’d probably find that the expense is a very ugly number.
Alternative: If you are captivated by the idea of getting a discount, buy shares of Tri-Continental Corporation, which mixes stocks and bonds. The fund sports an excellent long-term performance record, a 10% discount and a 0.46% expense ratio.
7. Cornerstone Strategic Investment
This closed-end fund dishes out enormous dividends, some from earnings, some from a return of capital. Yield-hungry investors are so in love with the payouts that they have boosted the market price of the fund’s shares to an 18% premium over their net asset value.
The operators of the fund have ably turned the premium to advantage. Every now and then they sell new shares at a premium. That increments the net asset value, enriching existing holders. The resulting performance record is very good, but it has a certain chain-letter flavor to it. The success of this strategy depends on a continuing stream of new customers willing to pay a premium.
Alternative: Avoid performance-enhancing drugs. Buy an index fund.
More From Forbes