Is a 15% yield too good to be true?

Short answer: the yield is usually real, in the sense that the cash genuinely arrives. What is misleading is calling it a return.

Canada has an unusual number of these. Our market is full of covered call and structured income products in a way that, say, the UK market is not, so a Canadian investor screening for income runs into double-digit yields on ordinary blue-chip baskets almost immediately. Here is how to work out what you are actually looking at.

Step one: total return, not yield

This one test eliminates most of the field, and it takes two minutes.

Find the fund’s total return — price change plus distributions — over the longest period available. Then compare it against the yield.

• Yield 15%, total return 4% a year? The unit price fell about 11% a year. You received 15% and lost 11% of your capital annually to fund it.
• Yield 15%, total return 13%? Now you have something worth examining.

Yield describes a payment. Total return describes what happened to your money. A fund can pay any yield it likes for as long as it has capital to hand back, so the payment on its own tells you nothing about whether the strategy works.

Step two: what is the payment made of?

Pull the tax breakdown — the T3 characterisation, published annually by every Canadian fund. You will see something like eligible dividends, capital gains, foreign income, other income, and return of capital.

Return of capital is the number to look at. It is not income. It is your own investment being returned to you. It is not taxed on receipt, which is why marketing describes these funds as tax-efficient, but it lowers your adjusted cost base by exactly the amount received — so the tax reappears as a larger capital gain when you sell.

A modest slice of return of capital is normal and mostly harmless. A large and growing share, year over year, means the distribution has outrun what the fund earns and the gap is being filled from capital.

The failure mode to know about: cost base cannot go below zero. Once return of capital has repaid everything you originally paid, every further dollar is an immediate capital gain in the year you receive it. Cash arrives, tax is owed, and you sold nothing.

Step three: where does the yield come from mechanically?

Very high Canadian yields generally come from one of four places, and they carry different risks.

Covered calls. The fund sells away its upside for option premiums. You keep the full downside and cap the gains. Fine if you want current income in a flat market, expensive in a rising one. Premiums shrink when volatility does, so the yield is not stable.

Leverage. The fund borrows to hold more of the basket. Amplifies both directions, and the borrowing cost moves with prime — which has moved a lot recently.

Return of capital by design. Some funds target a fixed payout regardless of earnings. That is a withdrawal plan wearing a yield’s clothing.

Genuine high-yield underlying. Some sectors really do pay a lot — mortgage investment corporations, certain REITs, split-share structures. Higher yields here reflect real credit or structural risk, which is at least an honest trade.

Combinations are common. A leveraged covered call fund distributing partly from capital can advertise a very large number indeed.

Step four: the fee, including the one underneath

If the fund holds other funds, the headline management fee may exclude the fee charged by the fund inside it. What you care about is the all-in cost, which on some structured products lands materially above what the fact sheet leads with.

The questions in order

1. What is total return over the longest available period?
2. What share of the distribution was return of capital, and is it rising?
3. What has the unit price done over five years?
4. What is the all-in fee?
5. Has the distribution been cut before?

If total return is respectable, return of capital is modest and stable, and the price has roughly held, a high yield can be a legitimate income product that has traded away growth. That is a real trade, and for someone spending the income it can be the right one.

If total return is far below the yield and the price has been sliding for years, the fund is returning your capital on a schedule. There is nothing illegal or even hidden about that — it is all in the documents — but it is a withdrawal plan, and you should know that is what you bought.

Where this leaves you

High yield is not a red flag by itself. Unexamined high yield is.

The formula takes a headline yield apart into fee, foreign tax, and what actually reaches you after Canadian tax. What is a covered call ETF covers the most common structure behind these numbers.