When evaluating an investment fund or certain securities, the distribution yield is a metric for investors seeking to understand the return potential they can expect from their investment. It provides insight into the cash generating potential of a fund, including its dividends, interest income, and other distributions. In this article, we will explain what the distribution yield is, its components, and explore the concept of return of capital.
What Is the Distribution Yield?
The distribution yield represents the annual amount a fund pays out to its investors relative to its net asset value (NAV) or market price. This yield is typically based on the cash generated by the fund from its underlying assets, such as dividends, interest and capital gains. For example, if a fund pays out $5 per share annually and its current price is $100, the distribution yield would be 5%.
What Components Make Up the Distribution?
Distributions are primarily made up of the following components:
- Dividends: If the fund holds dividend-paying stocks or other securities, the dividends paid by these securities contribute to the distribution yield.
- Interest Income: For funds that hold bonds, fixed-income securities, or money market instruments, the interest generated from these investments is also a component of the distribution yield.
- Capital Gains: If the fund realizes capital gains by selling securities at a profit, it can distribute these profits to fund holders.
- Return of Capital: In certain circumstances, the fund may distribute principal or invested capital back to investors.
Why is Return of Capital Important?
Return of capital occurs when a fund distributes money to its investors that is not from its underlying earnings, but rather from an investor’s principal or invested capital. Essentially, it is a distribution of an investor’s original investment. This can happen for various reasons, such as when a fund is paying more to its investors than it is earning or when it is trying to maintain a constant distribution yield.
In terms of taxation, return of capital is generally not taxed at the time it is received. Instead, it is considered a reduction of the investor’s cost basis (the original amount invested in the fund). By reducing the cost basis, the return of capital may increase the taxable gain when the investment is eventually sold. This means that although the return of capital is not taxed initially, the investor will pay taxes on any capital gains when the asset is sold.
For example, if an investor initially invests $1,000 in a fund and they receive $100 in return of capital, the investor’s cost basis is reduced to $900. If the investor later sells the investment for $1,200, they will be taxed on a $900 cost basis ($300 capital gain) and not their original $1000 cost basis ($200 capital gain).
What are the Performance Considerations from Return of Capital?
Although return of capital increases the distribution yield, it should not be considered part of the overall return. This is because it does not reflect any cash generation or growth in the value of the investment. It is simply a return of the investor’s own money. Therefore, it does not contribute to the fund’s actual income or performance in terms of profit generation. In most cases, a fund’s NAV or a security’s price will decrease to compensate for the return of capital (cash outflow).
When analyzing a fund, it is important to distinguish between “true” cash generation (like dividends or interest income) and its reported distribution yield. Frequent returns of capital may give investors an inflated sense of the fund’s cash generation in the form of a higher distribution yield. However, the fund is really just returning an investor’s original investment back to them.
As the saying goes, “there is no free lunch”. If a fund has a distribution yield that is well above what you would expect in the current market environment, further investigation should be carried out. It may be that the fund is returning capital to shareholders and the distribution yield is not a reflection of the actual earnings. In certain situations, the entire distribution can be a return of capital.
When is Return of Capital More Commonly Used?
Return of capital is more common in certain types of funds or investment structures. Below are a few examples of such situations:
- High-Yield Investment Funds: Funds that target high distribution yields, such as income funds or certain closed-end funds, may pay out more to investors than they earn through regular income. To maintain the promised distribution levels, these funds may use return of capital to supplement their income. This is more common in funds that invest in high-risk or less liquid assets, where regular income generation can fluctuate.
- Split Share Corporations: These funds are structured to have two classes of shares: preferred shares and common shares. Preferred shareholders often receive fixed distributions, which may exceed the income generated by the fund. To meet these fixed distributions, the fund may return capital to investors, reducing the NAV over time. This ensures that preferred shareholders continue to receive their payouts, even if the fund’s income is insufficient.
- Real Estate Investment Trusts (REITs): Some REITs may also return capital, especially if the fund is focused on specific distribution yields. If the income generated from property rentals or other investments falls short of their payout objectives, return of capital is used to maintain stable distributions.
- Mature or Depleting Funds: In cases where a fund is in its later stages (such as an income fund nearing the end of its lifecycle), it might use return of capital to continue making distributions while gradually liquidating its assets.
The below example shows a split-share corporation. The first security is the preferred share component which receives all the dividends earned in the split share arrangement. The second security is the common share class.
These securities had the following reported distribution yields:
- Preferred Share Class – 8%
- Common Share Class – 15%
At first glance, these distribution yields look very appealing. However, upon further investigation, a sizeable portion of the distribution is coming from return of capital. In the case of the common share class, the entire distribution is from return of capital.
Conclusion
The distribution yield is an important metric for investors, providing a snapshot of the cash generation potential from a fund or security. However, it is important to understand the difference between a distribution yield and a dividend or bond yield. Understanding when and why return of capital occurs — especially in structures like split share corporations or funds with high distributions — can help investors make more informed decisions and avoid misinterpreting the fund’s performance or earnings potential.
Disclaimer: This information is not intended to be comprehensive investment, tax or legal advice applicable to the individual circumstances of a potential investor and should not be considered as personal investment advice, an offer, or solicitation to buy and/or sell investment products. Every effort has been made to ensure accurate information has been provided at the time of publication, however accuracy cannot be guaranteed. Interest rates, market conditions, tax rules and other factors change frequently and past investment performance does not guarantee future results. The manager accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained herein. Please consult an investment manager prior to making any investment decisions.