The income illusion

With interest rates at all-time lows, investors are desperate for yield. But focusing only on income can often lead to a bad outcome.



From the September/October 2012 issue of the magazine.


Investors have a lot to worry about these days but if you’re trying to live off the proceeds of your portfolio, one concern trumps all others: low interest rates. As of mid-August, 10-year Government of Canada bonds were paying about 1.8%, not even enough to outpace inflation.

“I feel for people,” says Alan Fustey, portfolio manager at Index Wealth Management in Winnipeg. “Fifteen or 20 years ago, you could always find a coupon around 10%. Then it went down to 8%, then 5%, and now if your portfolio is largely fixed income, you just can’t get that yield anymore.”

The appetite for yield has spurred many Canadians—especially those in retirement—to modify their investment strategy. That’s understandable: after all, a retirement portfolio is supposed to generate cash flow to meet your expenses. The problem is many have lost sight of the big picture, and that can lead to poor decisions. “People are blindly looking for yield and not really understanding the consequences,” says Fustey.

Most investments deliver some combination of yield (income from interest or dividends) and price appreciation. Both are equally important and together add up to an investment’s total return. What’s often forgotten is that one usually comes at the expense of the other: bonds with higher coupons can bring a capital loss, stocks with higher dividends may experience slower growth, and so on. Investors run into trouble when they look at only one side of the equation.

“Right now the flavour of the month is yield, yield, yield,” Fustey says. “But at the end of the day there is always a price. You are always giving something up.” Here are four common examples that can help you avoid eating tomorrow’s lunch today.


Say you’re comparing bond funds and notice the iShares 1-5 Year Laddered Government Bond Index Fund (CLF) pays a distribution of 4.5%. That sounds awfully tempting when you consider that a ladder of one- to five-year GICs (which has the same level of risk) yields about 2%. Indeed, this difference is what prompted one well-known financial writer to recommend CLF because it offers “better returns than GICs.” But this simply isn’t true.

Bond math is tricky, but the most important idea is that when interest rates fall, bond prices go up. To understand why, imagine a five-year bond with a face value of $1,000 that pays a 4% rate of interest (or coupon), which is $40 annually. Now imagine a year later rates have fallen one percentage point. Our original bond now has four years left to maturity and is still paying $40 in interest, while new four-year bonds are paying just 3%, or $30. If you want to buy a four-year bond today, which would you choose: the old one paying 4%, or the new one paying 3%?

Obviously, you’d want the one paying more interest—but so does everyone else. So the bond paying 4% will now carry a premium: it would sell for about $1,037. When it matures, the investor will get back only the face value of $1,000, so he suffers a capital loss of $37. That will offset some of the higher income he’ll receive over the four years. Overall, the bond’s total return will work out to 3% annually—exactly the same as if he’d bought a new bond at current rates and paid face value.

OK, back to our government bond fund from iShares. The reason it pays that hefty 4.5% distribution is that all the bonds in the fund were issued several years ago, when interest rates were higher. They were purchased at a premium, and when they are eventually sold the fund will incur a series of capital losses that will offset most of that 4.5% coupon.

That’s why investors need to make decisions based on a bond fund’s yield to maturity. This figure—which should appear on a bond fund’s website—estimates the fund’s total return based on interest income minus any capital losses. In the case of CLF, the yield to maturity today is about 1.5%—and that’s before subtracting management fees. An investor who puts $100,000 into this fund might collect $4,500 in income from the 4.5% yield, but he will also lose more than $3,000 of capital.

You’ll notice CLF’s yield to maturity is significantly less than the yield on a five-year GIC ladder. That’s what you should expect, since GICs usually pay more interest than government bonds. Bottom line: an investor who considered only the income component of these two investments would have chosen the one with the lower total return.


Many investors take for granted that they need to focus on dividend-paying stocks in retirement, as opposed to using a more diversified strategy that also includes growth stocks with little or no yield. There’s nothing wrong with focusing on dividends, especially if you’re investing outside an RRSP or RRIF, since the tax advantage of Canadian dividends can be enormous. However, just like bond buyers, dividend investors sometimes forget there’s a trade-off.

Take the idea that spending $1,000 of dividends is “living off income,” while selling $1,000 worth of shares is “depleting capital.” Academics have spent decades arguing that these two actions are essentially the same, but the message hasn’t sunk in. “That’s a hard one, because it’s totally behavioural,” says Steve Lowrie, portfolio manager at Lowrie Financial in Toronto. “People think that dividends are found money: they don’t realize it’s just money coming out of the company that could have been used to buy back shares or expand the business.”

Think of it this way: if a company pays you a $1,000 cash dividend, it must be worth $1,000 less than it was before. That’s why you’ll often see a company’s share price decline a few days before an announced dividend is paid. That confuses many investors. As one finance professor wrote: “I once heard a fellow say, ‘I don’t understand it; every time this stupid stock pays a dividend, it goes down. You would think it would go up.’” That’s a classic example of the income illusion at work.

Investors who gobbled up income trusts fell into a similar trap several years ago. Thanks to a tax loophole the government has since closed, these companies paid out generous distributions, often 8% to 10% or more. But often more was going out than coming in. “Generally these were depreciating assets, so you were getting some return, plus a piece of your principal back,” says Alan Fustey. “People would call it yield, but that makes no sense, because you’re depleting your original capital.”

Another common misunderstanding arises when investors measure their “yield on cost.” Say you bought a stock 10 years ago for $20, when it was paying a dividend of 4%, or $0.80 per share. The dividend increased 8% annually, so a decade later it’s grown to $1.73 per share. Some investors will divide the current dividend by their original cost and say their investment is yielding 8.6% (1.73 ÷ 20 = 0.086). But a stock’s true yield is its dividend divided by its current price, not the price you paid for it. Yield on cost is an almost meaningless figure that can lead investors to badly overestimate their total return.

None of this means dividends are irrelevant. “With all of the accounting shenanigans that have gone on, dividends are something that can’t be masked—at least not entirely,” says Dan Hallett, director of asset management at HighView Financial Group in Oakville, Ont. He argues dividends can signal management’s confidence in the business and its earnings outlook, and there is evidence to suggest that companies with strict dividend policies are less likely to squander their profits on ill-advised acquisitions. “But I would agree it is largely a psychological love affair with dividend strategies in general.”

Return of Capital

Some of the most popular mutual funds around are those that pay unitholders a fixed distribution each month. The BMO Monthly Income Fund, for example, pays out $0.06 per unit every month, which currently works out to about 10% per year. That juicy yield helps explain why the fund has attracted some $5 billion in assets.

The thing is, this distribution far exceeds what the fund can produce in bond interest and dividends. So in order to maintain its monthly payout, the fund has to sell some of its assets and pass along the proceeds to investors in the form of “return of capital.” This is essentially giving you back your own money and calling it income.

There’s nothing wrong with generating cash flow from a combination of interest, dividends and dipping into capital. (In fact, that’s exactly the approach we recommend in “A better way to generate cash flow,” below) “In the same way that there’s no difference between receiving a dividend and selling a few shares to generate cash flow, there is no difference between having your mutual fund automatically pay a distribution and you selling a few units,” says Hallett. “The problem is with investors’ perceptions of what’s really happening, and with how these funds are sold.”

The fact sheet for the BMO Monthly Income Fund says the fund is appropriate if “you want regular monthly cash flow with the potential for capital gains.” But as Hallett points out, “With that level of distribution, there’s no way you can get capital growth.” This is a fund of half stocks and half bonds, paying almost 10% and charging 1.57% in fees. It would only enjoy capital growth if the stocks appreciated by about 20% a year.

In fact, the price of the BMO fund has fallen from $9.30 in mid-2003 to about $7.30 as of mid-August, a decline of more than 20% over 10 years. Its total return over this period was much lower than its payout: 5.3% annually, which is about what you’d expect from a balanced portfolio of bonds and dividend stocks. It’s a perfectly good balanced mutual fund, so long as investors understand that about half the “income” is just their own money being returned to them.

Return of capital isn’t just a feature of monthly income mutual funds: even dividend ETFs use the technique to smooth out their payouts. From 2009 through 2011, for example, about one-sixth of the cash distributions from the iShares Canadian Dow Jones Canada Select Dividend Index Fund (XDV) were return of capital. To see whether this applies to your own ETFs, visit their web pages and click the “Distributions” tab for details.

Covered Calls

If you need proof that many Canadian investors are blinded by their search for yield, look no further than the extraordinary popularity of ETFs that use covered calls to generate income. There are now 19 of these trading on the TSX, and in about 18 months they’ve gathered about $2 billion. Given that these ETFs boast yields in the range of 9% to more than 18%, it’s easy to see the appeal. But once again, investors may be setting themselves up for disappointment.

A call option is a contract that gives the holder the right to buy a stock at a certain price within a specified period. Imagine you own 1,000 shares of BigBank, currently trading at $50. You might sell (or write) call options on those shares with a strike price of $52 and an expiry date six months from today. The person buying the call will pay you a premium of, say, $1.20 per share. Over the next six months, if the stock never increases to $52, the call options will expire worthless: you get to keep your shares in BigBank, any dividends the company paid, and the $1,200 premium.

However, if the stock rises above the strike price, the holder of the call option will buy the shares from you for $52. You will still get to keep the $1,200 premium, but if you still want 1,000 shares of BigBank you’ll have to buy them back at the higher price. That’s the trade-off with this strategy: if markets move upward quickly—and they do that all the time—you could forfeit a big gain.

“What you’re doing is trading some potential return for some certainty,” says Alan Fustey, who regularly writes covered calls for his clients. (A call is said to be “covered” if you actually own the underlying stock. If you don’t, it’s a “naked call.”) “Many of them are looking for consistent levels of income in retirement and if we’re not able to generate enough through bond interest and dividends, we can write calls to get them closer to what they need.” But he’s careful to ensure his clients understand they’re giving up some upside. “There’s no free lunch. We know if the market goes up 10%, we might only get 6%.”

In theory, call-writing strategies should lag in strong bull markets but outperform when markets go sideways, rise gradually, or decline. But as the past year has shown, covered call ETFs can lag during falling markets if there is a lot of volatility. The Horizons Enhanced Income Equity ETF (HEX), for example, currently sports a yield of over 10%, yet its total return over the 12 months ending in June was –11.8%, worse than the overall Canadian market. Over that same period, the BMO Covered Call Canadian Banks ETF (ZWB), boasting a yield of 7%, returned –3.3%. That’s 0.5% less than if you had simply held those same bank stocks and not engaged in any call writing.

Fustey is concerned investors flocking to covered call ETFs may simply be chasing yield. “There has to be some degree of misunderstanding about how these work.” They may not realize some of these ETFs write calls on 100% of the stocks in the portfolio, something he rarely does. (Others do so on only 25% to 50% of a portfolio, reducing income but giving investors upside if the stock rises in price.)

He worries some ETFs hold a relatively small number of companies in just a single sector. “Look at the ones focused exclusively on Canadian banks—you’re buying a narrow segment of an already narrow market.” Fustey prefers to write calls on broad-based index ETFs tracking the entire Canadian and U.S. markets, which provides more diversification and less volatility.

Hallett doesn’t recommend call-writing strategies. “You’re saying you will take the cash now and give up some upside but in the fullness of time, on a total-return basis, I don’t see how that works in your favour. If history is any indication—admittedly, it might not be for your investment horizon—you’re probably giving up more than you’re getting.”

A Better Way to Generate Cash Flow

The idea that retirees should live off the income from their portfolios without dipping into principal goes back a long way. It made sense in the 1980s and 1990s, when 10-year government bonds yielded 9% or 10%, and inflation was less than half that rate. Today, only the wealthiest Canadians can hope to pull this off. “For most people it’s an unrealistic expectation that you can live purely off income over a long period,” says Dan Hallett of HighView Financial Group. “I just don’t think that most people will have saved enough to do that.”

A more realistic approach is to use a strategy that generates cash flow using a combination of bond interest, dividends and a dollop or two of principal. After all, that’s exactly what you do when you buy an annuity: you turn a lump sum into a regular stream of income that will last throughout your lifetime, but isn’t expected to last for eternity. Depending on the risk you’re willing to take, the size of your nest egg, and how long you live, this approach should allow a withdrawal rate of about 4% to 6% for 30 years or more. If you keep to the lower end of that range, you should be able to increase your withdrawals each year to keep pace with inflation.

But how do you manage the process? Portfolio manager Steve Lowrie sets aside a cash reserve covering three years’ worth of expenses, and clients use this account for their regular cash flow. The rest of the portfolio is invested in a globally diversified blend of stocks and bonds. When it’s gone up in value, he takes some profits and replenishes the cash reserve. The three-year buffer usually gives him enough time to ride out market volatility. “This was really helpful during 2008–09,” he says, “because my clients could meet their cash flow needs and ignore the rest of the portfolio. Then when things rebounded, I rebalanced by selling stocks. It gives you a lot of flexibility.”

Hallett likes that approach too, but warns investors it can be difficult to manage without an adviser. “This total-return approach is a bit more high-maintenance, but realistically it’s the best way to address cash-flow needs. There’s a little bit of timing involved, because you want to replenish that short-term account when your other assets are on a bit of a high. Just don’t get hung up on the timing: it doesn’t need to be perfect.”

16 comments on “The income illusion

  1. When we look as a whole we can see the value of money is going down, that what is reflecting in the interest rates. It all started with the recession and still continuing. The world is not out yet completely from the after effects of recession.


  2. I don’t understand your comment that receiving a dividend of $1,000 is the same as selling $1,000 worth of the stock in question. The former does not decrease your capital while the latter does.


    • Wow. You kind of missed the whole point with that statement. What the author emphasized is that the $1000 dividend is money coming out of the company, i.e. the company’s capital is reduced by $1000. Therefore, a $1000 dividend or selling $1000 worth of capital stock is the same thing – it just looks different.


  3. Great article tackling some really complicated financial terms. Its written is such clear English that even I managed to understand most of it (some of it I might need to read again). Wish more financial articles were written with such clarity.


  4. All wishfull thinking how to deal with 7.2 % at age 71 up to 20% at age 90 RRIF minimum withdrawn rule, the IRA the US counterpart stand at 3.5% even.,


    • Wow Mameo. You miss the point. The goal behind mutual funds with monthly distributions is that they increase your capital as well as providing a monthly return. The monthly distributions are paid out of capital gains, dividends, interest or return of capital. and can be taken in cash or reinvested in the fund. Granted, a return of capital does decrease your capital but the other sources of distributions do not.

      On the hand, simply selling $1,000 of a mutual fund or any stock for that matter will obviously decrease the value of your holding in that fund or stock by that amount.

      In the future, please get a clue before being so quick criticize someone’s else’s comment


  5. Let me give you my perspective on the “difference between $1000 dividend and $1000 stock sale”. The reason that the author says that they are equivalent is that they, essentially, have the same outcome. Imagine that you 100% own all the shares of a company, that it operates all year and generates $1000 worth of profit. The company has two choices. It could keep the money in its own bank and, all other things being equal, the value of the company would go up by $1000. It is then possible to imagine that, you, as the sole shareholder, sell $1000 worth of shares to someone else (capital sale) and keep the cash. The remaining value of your capital is not reduced at all from its original position (as some have suggested above),. Alternatively, the company could dividend out the money straight away as income to you. You get $1000 dividend cash. The value of the company didn’t increase, because none of the profit stayed in the company. The end result really is the same. You may think it is different if you are not the sole owner of the shares, but it isn’t. Even if you own a tiny fraction of the company, the math is identical. You can get your share of the dividend income or sell your share of the capital gain. Interestingly, in Canada, the tax rates for the two choices are markedly different. Capital gain is taxed at half the “regular income” level (which includes all non-Canadian dividends). Therefore, it is much, much better to sell a few of your (non-Canadian) shares after a capital gain than it is to receive dividend income. There is some tax advantage in “approved Canadian Company dividends”, but capital gain is still superior to maximize the after-tax return. Hope that helps someone make sense of this. By the way, I have tried to explain this to Mexican immigration authorities who want to see evidence of my “income”. It wasn’t an easy conversation trying to explain that capital gain is just another form of income, but is chosen every time because it is more tax efficient.


    • I was under the impression that dividends are taxed more efficiently up to a certain point ($80k give or take) due to federal and varying provincial dividend tax credits and after that, capital gains become more efficient.


    • By your analogy selling $1000 is the same as $1000 in dividends. That looks the same on paper at that particular moment but now you have less shares to generate income for the next month so you will have to sell more shares again to get the same value in cash. this starts a spiral of depletion of capital which eventually will bankrupt the fund. I have been living off my dividends for years and the value of the funds have appreciated greatly. Hmmmm, how weird is that according to your ideas?


      • You are forgetting that in John’s example, the value of the company has gone up by $1000 so that even if you sell off the $1000, the value you have left is still $100,000. Same as if you had paid yourself the $1000 dividend. You are making the exact mistake described in the article.


        • P.s. I should mention I was using $100,000 as the starting value of the company that generated the $1000 profit for the sake of the example.


    • Also I pay less tax on dividend income than on capital gain income so I don’t know how you manage to pay more on dividends.


  6. Cash flow is the most essential component to wealth creation. If I can build a secondary income stream via dividends, I can borrow money at a cost of debt less than the annual return I’m getting from my dividends, I can then use the leverage to buy real assets, like a condo, and fill the property with paying tenants. The name of the game is cash flow velocity to accumulate assets, not sitting around for 40 years hoping you have a “nest egg” to live off of.


  7. Thank you for this article. I wish I had researched Monthly Income Funds more seven years ago. It seems that the more I inquire, my trust factor diminishes more in advisors (senior or not). If only RRSP money could be put in a Matress! :)

    Until this latest sudden drop in the TSX, I really did what was recommended “Don’t look at the balance of my RRSP everyday”. I had survived the 2008 collapse and saw the market and my RRSP losses come back. However, I thought maybe its time to consider protective action.

    I examined my holdings and when I looked at each fund, I came to the realization that the Monthly Income Fund was not doing as well as was expected based on the hype by the Senior Investment Advisor (not my usual contact person). Based on his positive approach, I bought the advice to get into a monthly income, the one his bank was promoting. It was the way to go! I was retired, did not need the monthly income yet and usually placed my RRSP into GICs or Balanced Funds. I only heard “guaranteed 5% monthly return” and did not ask enough. I was convinced that, more likely than not, if I followed the Advisor’s advice, I reinvested my payouts with the fund to be better off when I would need the income.

    I noted that over the last three years years, I had reinvested more that $7980 but the market value was only up $1900. “What! Oh no, $6000” But than reality sunk in…if I had NOT reinvested the $7980 in monthly income, the fund market value would be down $7980.

    I have adopted the opinion that the $6000 was paper money. If not then I would not be able to “move on”. Holding onto any anger would do me no good :) :) :) Your article was so informative and I enjoyed reading it andthe comments.

    Again, thank you!


  8. this is the best article I ever did read in order to understand the very complicated financial world. so thank you so much for your explanation. now my question is what do we really do with the money we have saved. taking some return and some principle is a very clear and reality concept for me. I’m just not sure who to trust to do it right for me. also the management fees can be high and if I get GI C’s I don’t have to pay for it. as in today’s rates a manager would have to make more then 4 % return to cover this. thanks again…


  9. We are seeing all these problems for last 3 to 4 years. Prior to that Trusts were giving good income which was persistent for more than a decade.


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