A recent cable news segment touted two dividend-focused funds as smart income plays, praising their “generous” yields. But a closer look reveals a different story: both funds delivered total returns and risk profiles similar to the bond market — and one relied on return of capital to inflate its yield. When headlines sell income, investors should check the fine print.
The segment featured a regular contributor whose expertise centers on “dividend yield.” His recommended investments, shown in the table below, featured stated yields of 8.2% and 16%, respectively. The first is a municipal bond closed-end fund, and the second is a leveraged mortgage Real Estate Investment Trust (REIT) with a financial leverage ratio of 11.4, according to Morningstar. In practical terms, this means the REIT uses $10.40 of debt for every $1 of equity to finance its assets.
What was described as “dividend” yield is, in fact, a “distribution” yield. According to Morningstar data, a significant portion of the municipal bond fund’s distribution consists of return of capital, which has been counted as yield in recent years. Essentially, the fund is returning maturing bond principal to shareholders, thereby overstating the income yield.
The REIT’s current distribution yield of 16% might tempt some investors to think, “Why take any equity risk in my portfolio when I can get a 16% yield?”
To be fair, both recommended funds have offered some long-term diversification benefits relative to the broader U.S. bond benchmark, as shown in green below.
However, compared to the total returns of the S&P 500, these funds are in no way, shape, or form a substitute for a well-diversified equity portfolio. At best, they should be considered potential diversifiers within a thoughtfully balanced investment strategy.