You’ll see them at your local bank branch, those amateurishly handwritten whiteboard signs advertising a $700 or $800 monthly income on a $100,000 investment. That’s equivalent to around a 9% annual yield. With your average bank savings account paying some fraction of 1%, that yield looks mouth-wateringly good for yield-starved investors. Until you ask someone about it. At which point you’ll learn the truth.
What you’ll usually discover from the in-house advisor is that the 9% yield is from one of the bank’s income mutual funds, which, unfortunately, “just isn’t sustainable at this time.” But what does that mean? And why advertise it if it isn’t “sustainable.”
How income funds work
Most income funds hold a combination of fixed-income securities like bonds, preferred shares, and dividend-paying stocks. It’s highly unlikely they can achieve a 9% yield from assets they hold currently. Even the iShares Canadian Financial Monthly Income ETF (TSX: FIE), an exchange-traded fund dedicated to a mix of income-producing assets, posted a recent distribution yield of 6.72%.
What the bank advisor means when she says the fund’s distribution is not “sustainable” is that the fund is paying out more in distributions than it actually makes in income from the assets it holds. Now, there’s nothing particularly wrong with that, and many funds do this from time to time. But where does the extra money come from? In a word, you.
Getting your own money back
It’s called “return of capital.” The fund is effectively distributing back to unitholders income derived from its holdings plus a certain amount of their own money. (Some funds may also use “return of capital” for purposes of tax efficiency, as that portion of a distribution is not taxable, but that’s another story.)
Clearly, there are some serious problems with this situation. First of all, the fund cannot distribute capital back to unitholders indefinitely without going out of business. As distributions continue at that high level, the fund’s net asset value declines. Second, investors would quickly rebel at being asked to pay, say, a typical 1.7% management expense ratio on a fund that simply gives you your own money back.
Inevitably, distributions are slashed
So usually, a fund that pays out more than it makes in investment income will eventually slash its distribution rate back to something approaching the reality of its expected income stream. Its NAV then usually creeps back up again.
Of course, when that happens, existing unitholders will see their monthly distributions slashed, sometimes quite dramatically. This can hit seniors and others who had been relying on that apparently rich monthly income stream quite hard.
If it sounds too good to be true…
It’s not difficult to understand why a bank branch would post a high-yielding investment product they have no intention of selling on a handwritten whiteboard at their entrance door. It’s a relatively easy way to get people who are looking for a solid monthly income stream – mostly pensioners or those close to retirement – to speak with one of the bank’s planners. They’ll typically then pull out the “unsustainable distribution” story, persuade you not to invest in the fund, and turn the conversation to some of the bank’s other, more realistic, income-producing products and services. It’s not exactly a “bait-and-switch” scheme, but it’s just a tad sneaky.
As usual, the old rule applies to mutual fund distribution yields as it does to anything else: If it sounds too good to be true, it probably is. Always check with a qualified financial planner or advisor before committing funds to any investment that has a yield that puts stars in your eyes.
© 2013 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.