The 8% Yield Looks Tempting. Here’s What You’re Really Buying

Anytime an 8% yield comes up, it’ll definitely get some attention. Considering the S&P 500 is only yielding around 1.5% right now, anything above that number, especially five times above that number, it begs the question: What’s the catch? Whether this portfolio is for a retiree or a retail investor, the idea of an 8% yield will look pretty appealing, considering the ultimate goal is to turn this portfolio into something that can pay the bills.

However, it’s important to remember that the yield alone won’t tell you the whole story. This kind of portfolio isn’t going to be filled with blue-chip names everyone knows that have decades of steady dividend increases that make people feel like their portfolios are safe from anything.

Instead, getting into a position where a portfolio yields 8% is going to require some different ways of investing, including looking at things like REITs, BDCs, or covered call funds. On the plus side, each one has its own way of producing this kind of income, but each one also carries different kinds of risks that can rise or fall depending on both the market and the overall economy.

What an 8% Yield Actually Represents

The income might be steady, but understanding that these investments will work differently from traditional investments is a major component before actually making the investment. Understanding these investments is equally important so you know exactly where your money is going.

For example, REITs are required to distribute at least 90% of their taxable income to shareholders, which helps explain why they pay higher yields than the broader stock market. This kind of high yield doesn’t mean that a REIT is in any kind of financial trouble, only that this is a legal requirement based on the type of business.

Business development companies work in a similar way, as they will lend money to both small and medium-sized businesses and pass this interest income directly on to their shareholders. The higher yields are tied directly to the way BDCs are structured and the kind of investments they make in order to generate revenue.

How to Evaluate Whether the Yield Is Durable

Asking whether an 8% yield is too high isn’t going to be the right question for most people, but whether or not this percentage is supported by something that is actually real. Before buying into any high-yield position, REIT, BDC, or otherwise, there are three things that any investor should look at closely. The first is the kind of payout source, the second is the coverage ratio, and the third is to take a long look at the company’s distribution history.

How these investments pay out matters because each investment is going to respond differently as market conditions shift, for better or worse. If rental income goes up or down, REITs have to make adjustments that can impact investor payouts, and the same goes for BDCs based on where interest payments are in any given quarter.

All of these things will respond differently as market conditions shift. Also worth considering is that any fund that will return capital back to shareholders to keep its distribution high might not be generating any real income. It could actually be liquidating itself, giving proceeds back to investors, and hoping nobody figures out the math too quickly.

What Patient Investors Tend to Get Right

The investors who are doing well with a high-yield portfolio will not just be the people who discovered high-yields. There is a better chance it will be the people who tried to match their actual income needs, whether monthly or annually, and who found the highest yields that would help them hit that number. Then there is the idea of holding these positions even when the market might go negative, as long as the income generation is still there.

Having an 8% yield that is backed by both a durable cash flow stream and a long distribution history might just be the key to becoming a real income tool. The same 8% yield on a fund that has a shrinking coverage ratio and a history of dividend cuts won’t give you the same level of long-term comfort. Ultimately, the yield should be where any conversation starts about investing in a REIT, BDC, or covered-call fund, and not where it ends.

So What Are You Actually Buying?

When you put your money into an 8% yielding fund, understanding what you are really buying, or getting, is the right way of thinking. The thing to remember is that you are not buying a company that is generating so much profit that it is left with no choice but to hand some of its money back to shareholders. This isn’t the right answer at all.

What you are actually buying is a manufactured income stream, one that is likely available to you because of some legal mandate, an option strategy, or some kind of credit exposure. Yes, the income is real, that much is true, but what many investors don’t stop consider is the source of the income.

This distinction might not matter to everyone, but understanding it should, because manufactured income is going to behave differently when the market is under pressure. A covered call fund’s distributions will shrink as volatility drops. A BDC’s income is going to get squeezed when credit conditions tighten. A high-yield bond fund will feel the pain of every recession in its payout before the broader market feels the same pressure.

Now, none of these make these investments bad, but it does make them investments that require specifically understanding what you are getting before money goes back in and out.

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