GV Finance

For those new to the world of investing, the concept of dividend stocks holds an almost magnetic appeal. It represents the quintessential dream of passive income: owning a piece of a company that pays you, quarter after quarter, simply for being a shareholder. This income can be used to pay bills or, even more powerfully, be reinvested to buy more shares, creating a compounding effect that can build significant wealth over time.

In this search for income, it is easy to become mesmerized by the brightest-shining objects. You will inevitably encounter stocks or funds that boast tantalizingly high dividend yields—8%, 10%, 12%, or even higher. When the average S&P 500 company yields around 1.3%, and the vaunted “Dividend Aristocrats” (companies with 25+ years of dividend increases) average around 2.25%, a 10% yield feels like a shortcut to financial freedom.

This article is designed to serve as a critical warning: in financial markets, there is no free lunch. An abnormally high dividend yield is almost never a bargain. More often than not, it is a distress signal in disguise—a sign of a deeply troubled company, an unsustainable payout structure, or a complex financial product that is simply returning your own money to you.

This is the “dividend trap”. It lures income-focused investors with the promise of a high payout, only to spring shut, leaving them with a slashed dividend and a significant loss of their original principal.

The goal of this guide is to move you beyond the temptation of “yield chasing.” We will dissect why a yield is high, explore the high-risk asset classes where these yields are found, and most importantly, provide you with a professional-grade toolkit to analyze the sustainability of any dividend. Finally, we will demystify the complex tax implications of your investments, ensuring you understand not just what you earn, but what you keep.

Part I: Anatomy of a Dividend Trap

Before you can spot a trap, you must understand its mechanics. A dividend yield is a simple ratio: the company’s annual dividend per share divided by its current stock price.

Dividend Yield = Annual Dividend Per Share / Current Share Price

There are only two ways for this percentage to get exceptionally high:

The company dramatically increases its dividend.
The company’s stock price dramatically falls.

While the first scenario happens (often in cyclical industries during a boom), the second is far more common. The stock price falls because the market, as a whole, has looked at the company’s future prospects and concluded it is in trouble. The market is signaling that future earnings are in jeopardy and that the dividend is at high risk of being cut.

The high yield you see is often a mathematical ghost—a “trailing” yield based on dividends paid over the past 12 months, which have no bearing on what will be paid in the future.

Case Study: The 48% “Yield” That Was a 99% Trap

Let’s look at a textbook example from 2025: ZIM Integrated Shipping Services (ZIM).

A new investor screening for high-yield stocks in November 2025 would have seen ZIM and their eyes would have lit up. With a stock price of $15.85, it had a trailing 12-month dividend of $7.60, giving it a staggering dividend yield of 47.99%. An investor might dream of putting $10,000 in and getting back $4,800 in a single year.

But a professional investor asks, “Why?”

Understand the Business: ZIM is in the global container shipping industry, a notoriously hyper-cyclical business. Following the global pandemic, shipping rates soared to unprecedented levels, and companies like ZIM posted record profits. They passed these temporary, windfall profits on to shareholders as massive dividends.
Look at the Price: The stock price had fallen significantly from its boom-time highs. The market, which is forward-looking, knew these record-high shipping rates were normalizing.
Check the Forecast (The “Smoking Gun”): A look at analyst consensus estimates for ZIM’s future reveals the trap in plain sight.

2025 (The “Good” Year): Analysts estimated earnings per share (EPS) to be profitable, in a range of $2.94 to $3.78.
2026 (The “Bad” Year): The forecast showed a swing to a massive loss, with estimated EPS in a range of -$3.41 to -$5.19.
The Dividend Forecast: As a direct result, the annual dividend was projected to be cut by over 99%, falling from an estimated $3.97 in 2025 to as low as $0.01 to $0.04 in 2026.

An investor who bought ZIM for its 48% yield would not only see that income stream evaporate in 2026 but would also be left holding the stock of an unprofitable company, likely leading to a devastating loss of their initial $10,000 investment. This is the dividend trap, and it is the single greatest peril to a new income investor.

Part II: The High-Yield Universe (Where 10%+ Yields Live)

You will not find 10% yields among “blue chip” stocks like Microsoft, Apple, or Walmart. These high-quality, stable companies have average yields in the low single digits. To find double-digit yields, you must venture into complex, high-risk asset classes. The most common are Business Development Companies (BDCs) and Mortgage Real Estate Investment Trusts (mREITs).

1. Business Development Companies (BDCs)

What They Are: BDCs are funds that are publicly traded like stocks. They were created by Congress to provide capital (primarily loans) to small and medium-sized private American companies that may be too small or risky to get a traditional bank loan.
Why the Yield Is High: BDCs are typically structured as Regulated Investment Companies (RICs). To avoid paying corporate income tax, they are legally required to distribute at least 90% of their annual taxable income to shareholders as dividends.¹
Current (2025-2026) Risks: The private credit world has become flooded with cash from large institutional “hyperscalers”. This intense competition is forcing BDCs to either accept lower interest rates on their loans (which shrinks their income) or, to maintain high yields, make “forced deployments” into lower-quality, riskier loans. This environment is putting significant pressure on the sustainability of their payouts.

2. Mortgage Real Estate Investment Trusts (mREITs)

What They Are: It is critical to understand that mREITs do not own physical property like apartment buildings or offices. Instead, they invest in financial assets: mortgage-backed securities (MBS) and other mortgage-related debt. Their business model is to borrow money at low short-term interest rates and use that capital to buy higher-yielding long-term MBS. Their profit is the “net interest spread” between what they earn and what they pay.
Why the Yield Is High: Like BDCs, REITs must also distribute at least 90% of their taxable income to shareholders. As of late 2025, the mREIT sector yield was approximately 12.75%. Their business model also uses a high degree of leverage, which magnifies both potential gains and potential losses. The high yield is, in part, the market’s way of compensating investors for this amplified risk.
Current (2025-2026) Risks: The mREIT business model is entirely beholden to “the unpredictable interest rate path”. They are trapped in a “catch-22”:

If Rates Rise Unexpectedly: Their short-term borrowing costs spike, crushing their profit spread.
If Rates Fall (as expected in 2025-2026): Their borrowing costs fall (which is good), but this triggers a wave of homeowners to refinance their mortgages. This is known as “prepayment risk”. Their high-yielding MBS assets are paid back early, and the mREIT is forced to reinvest that cash at the new, lower market rates, once again compressing their profit.

Part III: The Professional’s Toolkit: How to Judge Sustainability

Now that you know where to find high yields and the risks involved, you need the tools to analyze them. A new investor looks at the yield; a professional investor looks at the coverage.

Red Flag #1: The Payout Ratio (The Wrong vs. The Right Way)

The most important metric for dividend safety is the payout ratio: the percentage of a company’s earnings being paid out as dividends. If a company earns $1.00 per share and pays a $0.50 dividend, its payout ratio is 50%. This is healthy. If it earns $1.00 and pays $1.00 (100% ratio), it has no margin for error. If it earns $1.00 and pays $1.20 (120% ratio), it is, by definition, unsustainable and is funding the dividend by taking on debt or liquidating its own assets.

This is the single most important rule for new investors: Do NOT use the standard Earnings Per Share (EPS) payout ratio you find on many finance websites to analyze BDCs and REITs. It is a completely useless metric for these sectors.

GAAP (Generally Accepted Accounting Principles) requires these companies to report non-cash expenses like depreciation, which makes their EPS appear artificially low. You must use the industry-specific metrics that show their actual cash flow.

The Correct Metric for BDCs: Net Investment Income (NII)

For a BDC, the true “profit” is its Net Investment Income (NII). This is the interest income from its loans minus all its operating expenses and borrowing costs. This is the only sustainable source of the dividend.

The Litmus Test: Net Investment Income (NII) per share >= Dividend per share

Let’s apply this test to BDC examples from 2025:

Sustainable (But Tight): Ares Capital (ARCC)

Data: In its third-quarter 2025 financial report, ARCC reported NII of $0.48 per share.
Dividend: It declared a quarterly dividend of $0.48 per share.
Analysis: The NII exactly covers the dividend (100% coverage). The dividend is sustainable for now, but there is zero margin for error. This reflects the sector-wide income pressure previously discussed.
Highly Sustainable (The “Gold Standard”): Main Street Capital (MAIN)

Data: In its preliminary Q3 2025 results, MAIN reported Distributable Net Investment Income (DNII) between $1.01 and $1.05 per share.
Dividend: Its regular quarterly dividend paid during that period was $0.765 per share ($0.255 x 3).
Analysis: MAIN’s income (over $1.01) far exceeds its regular dividend ($0.765). This is a very safe, low-risk coverage ratio of over 130%. This “spillover” income is what allows MAIN to also pay supplemental dividends to investors. This is what dividend safety looks like.

The Correct Metric for mREITs: AFFO or EAD

For an mREIT, the correct metric is Funds From Operations (FFO) or, more precisely, Adjusted Funds From Operations (AFFO) or Earnings Available for Distribution (EAD). These metrics add back non-cash charges like depreciation to show the true cash flow available to pay shareholders.

The Litmus Test: EAD (or AFFO) per share >= Dividend per share

Let’s apply this test to mREIT examples from 2025:

Unsustainable (The Trap is Set): AGNC Investment Corp. (AGNC)

Data: In its Q3 2025 earnings release, AGNC reported its “net spread and dollar roll income” (its EAD metric) was $0.35 per share.
Dividend: During that same quarter, it declared and paid dividends totaling $0.36 per share ($0.12 monthly x 3).
Analysis: AGNC failed the test. It paid out more than it earned (97% coverage). This $0.01 per share shortfall, while seemingly small, is being funded by eroding the company’s own assets. The 14%+ yield is a siren song, and a dividend cut is highly probable unless market conditions drastically improve its profit spread.
At Risk (The Trend is Your Friend… or Enemy): Arbor Realty Trust (ABR)

Data: On October 31, 2025, ABR cut its quarterly dividend from $0.43 to $0.30 per share. In its Q3 2025 results, it reported Distributable Earnings (EAD) of $0.35 per share.
Analysis: At first glance, this looks safe. The new $0.35 in EAD comfortably covers the new $0.30 dividend (116% coverage). But a smart investor looks at the trend. The company’s EAD was $0.43 in the same quarter of the prior year. The dividend cut was a reaction to this decay in earnings, which was also accompanied by a rise in non-performing loans. The 11.9% yield exists because the market fears that earnings will continue to fall, leading to another cut.

Other Key Red Flags

Beyond the payout ratio, scan for these warning signs:

High Debt Burdens: A company with excessive leverage (a high debt-to-equity ratio) has limited financial flexibility. In a downturn, that company will be forced to choose between paying its lenders and paying its shareholders. The lenders always win, and the dividend is the first thing to be cut.
Declining Fundamentals: Is the company’s total revenue shrinking? Are its profit margins eroding? A high dividend from a dying business is a house of cards.
The “Yield Outlier”: If a company yields 10% while all its direct competitors yield 4-5%, the market is screaming that something is uniquely wrong with that one company.

The Sustainable Alternative: Dividend Growth

This analysis reveals a critical truth: sustainable income investing is rarely about finding the highest current yield. It is about finding high-quality companies with the financial health and competitive advantages to grow their dividend year after year.

Empirical data shows that portfolios focused on dividend growth have historically produced superior total returns (dividends + stock price appreciation) with lower volatility than portfolios that simply chase high-yield stocks.

When you buy a dividend growth stock with a 3% yield, that may not seem exciting. But if that company grows its dividend by 10% per year, in 10 years, your yield-on-cost (the annual dividend relative to your original purchase price) will be nearly 8%. In 15 years, it will be over 12%. You have successfully built a high-income stream by patiently investing in a healthy, growing business, not by gambling on a distressed one.

Part IV: The “Phantom Yield”: Deconstructing Complex ETFs

There is a third category of high-yield products that is perhaps the most deceptive of all: the Option-Income or Covered Call ETF. These funds, which have grown immensely popular, promise double-digit yields, often paid monthly.

How They Work: These funds own a portfolio of stocks (like the S&P 500) and then sell (or “write”) call options against them. A call option gives someone the right to buy those stocks at a set “strike price.” The fund collects a cash “premium” for selling this right, and it distributes this premium to you as “income”.
The Performance Trap: This strategy is mathematically designed to underperform in most markets.

In a Bull Market: Your upside is capped. When the stocks rise above the strike price, they are “called away.” The fund misses out on all the big gains.
In a Bear Market: You have full downside participation. If the market drops 20%, your fund also drops ~20% (minus the small premium, which offers trivial protection).
The Income Trap: The Section 19a Notice and “Return of Capital” (ROC)
The monthly cash payment you receive from these funds is a “distribution,” not a “dividend”. By law, this payment can come from three sources:

Net Investment Income (i.e., real dividends the fund received).
Capital Gains (i.e., real profits from selling stocks).
Return of Capital (ROC).

This last one is the trap. Return of Capital is not profit. It is the fund returning a portion of your original investment principal to you.

To see if you are being paid real profit or just your own money, you must find the fund’s “Section 19a Notice” (also called a “19(a) notice”). This legally required document estimates the sources of the fund’s distribution.

Let’s apply this test:

Case Study 1: Global X S&P 500 Covered Call ETF (XYLD)

The “Yield”: 12.13%
The 19a Notice: The fund’s 19a notice for its October 2025 distribution (a payment of $0.3967 per share) provided the following source estimate:

Net Investment Income: 3.14%
Return of Capital (ROC): 96.86%
Analysis: This is a “phantom yield.” An investor receiving $121 in “income” from this fund is actually getting ~$4 in real profit and ~$117 of their own money back.
Case Study 2: Amplify U.S. Treasury 12% Premium Income ETF (TLTP)

The “Yield”: 12.07%
The 19a Notice: The fund’s “30-Day SEC Yield” (the actual interest it earns from its Treasury bonds) was only 4.27%. Its October 31, 2025, 19a notice estimated that its distribution was approximately 82% Return of Capital.
Analysis: The fund earns 4.27% and distributes 12.07%. The ~8% gap is filled by handing investors back their own principal.

This is a “structured capital return” strategy. You are not earning a high income; you are liquidating your own investment and paying a management fee (expense ratio) for the privilege. This process, known as “NAV erosion,” causes the fund’s share price to slowly decline over time, destroying your principal.

Part V: An Investor’s Guide to Taxes on Dividends and Sales

The final piece of the puzzle is understanding the tax implications. What you earn is not what you keep. This is especially true for high-yield investments, which are often glaringly tax-inefficient.

(Note: The following applies to taxable brokerage accounts. Investments held in tax-advantaged accounts like 401(k)s or IRAs are not subject to annual capital gains or dividend taxes; instead, taxes are typically paid upon withdrawal).

At the end of the year, your brokerage will send you IRS Form 1099-DIV, which details all the distributions you received. Here is how those payments are taxed.

1. Taxation of Income: Ordinary vs. Qualified Dividends

Qualified Dividends (Form 1099-DIV, Box 1b): These are the “good” dividends. They come from most common U.S. stocks and qualified foreign corporations. They are taxed at the low, preferential long-term capital gains rates.
2025 Tax Rates (Qualified Dividends / Long-Term Gains):

0% if your taxable income is below $48,350 (Single) or $96,701 (Married Filing Jointly).
15% if your income is between $48,351 and $533,400 (Single) or $96,701 and $600,050 (Married Filing Jointly).
20% if your income is above those high-income thresholds.
Ordinary Dividends (Form 1099-DIV, Box 1a): These are the “bad” dividends. They are taxed at your high ordinary income tax rate, the same as your salary.
2025 Tax Rates (Ordinary Income): These rates range from 10% up to 37% for top earners.

The High-Yield Tax Trap: The vast majority of distributions from mREITs and BDCs are non-qualified ordinary dividends. An investor in the 24% tax bracket would keep only $0.76 of every $1.00 in mREIT dividends, versus $0.85 from a “qualified” dividend.
The REIT/BDC Exception (Section 199A): There is a silver lining. Under Section 199A of the tax code, investors can generally deduct 20% of their ordinary REIT dividends. This provision, which has been made permanent, effectively lowers the top 37% tax rate on these dividends to 29.6%. New legislation also aims to extend this same favorable treatment to BDC dividends, making both asset classes more tax-efficient than they first appear.

2. Taxation of Sales: Short-Term vs. Long-Term Capital Gains

When you sell an asset for more than you paid for it (your “cost basis”), you realize a capital gain. The tax rate on that gain is determined by one simple factor: how long you held the asset.

Short-Term Capital Gains: You held the asset for one year or less. Your profit is taxed at your high ordinary income tax rate (10% to 37%).
Long-Term Capital Gains: You held the asset for more than one year. Your profit is taxed at the low preferential 0%, 15%, or 20% rates.

This is why patient, long-term investing is so heavily favored by the U.S. tax code.

3. The Deferred Tax Trap: Return of Capital (ROC)

This brings us back to our “phantom yield” ETFs. As we established, ROC distributions are not taxed in the year you receive them. Instead, they reduce your cost basis. This creates a deferred tax time bomb.

Let’s use a simple example:

You Buy: You invest $10,000 in “ETF PHANTOM” at $100 per share (100 shares). Your cost basis is $10,000.
You “Earn” Income: Over the next three years, the fund pays you $2,000 in distributions, which you are thrilled with. You check the 19a notices and find it was 100% Return of Capital.
The Tax Effect: You pay no tax on that $2,000 in those years. However, the IRS requires you to reduce your cost basis by that amount. Your new adjusted cost basis is now $8,000 ($10,000 – $2,000).
You Sell: The fund’s price has (predictably) eroded due to the ROC distributions, and you sell your 100 shares for $90 each, getting $9,000 back.
The Tax Bill: You think you had a $1,000 loss ($9,000 sale – $10,000 purchase). But the IRS disagrees. For tax purposes, you have a $1,000 long-term capital gain ($9,000 sale price – $8,000 adjusted cost basis).

You have successfully received $2,000 of your own money back, watched your principal decline by $1,000, and you still owe capital gains tax on $1,000. This is the ultimate trap.

Conclusion: Become a Dividend Detective, Not a Yield Chaser

The allure of a high dividend yield is one of the easiest and most costly mistakes a new investor can make. It is a strategy of harvesting (often your own principal) rather than investing.

True, sustainable income investing is not about finding the highest yield today. It is about finding the most reliable and, ideally, growing yield for tomorrow. It is about focusing on Total Return—the combination of the income you receive and the capital appreciation of your principal. A 12% yield is worthless if your $10,000 principal shrinks to $8,000 in the process.

As you begin your investment journey, arm yourself with the tools of a professional. Be a “dividend detective,” not a “yield chaser.” Before you invest in any high-yield product, you must:

Understand the Business: Why is the yield high? Is it a cyclical boom (like ZIM) or a sign of distress?
Use the Right Metric: Ignore EPS for BDCs and mREITs. Find their financial reports and calculate the real dividend coverage using Net Investment Income (NII) for BDCs and EAD/AFFO for mREITs.
Check the 19a Notice: For any high-yield ETF, find the 19(a) distribution notice. Are you being paid profits, or is it a Return of Capital (ROC) “phantom yield”?
Look for Growth, Not Just Yield: Prioritize companies with a long history of growing their dividends. This is the most reliable sign of a healthy, shareholder-friendly business.
Understand the Tax Bill: Know how your income will be taxed. Are you receiving tax-efficient “qualified dividends” or tax-heavy “ordinary income”?

Building wealth through dividends is a marathon, not a sprint. By prioritizing the quality of the business and the sustainability of its payout over the temptation of a high-yield shortcut, you can avoid the traps and build a reliable, growing, and lasting stream of passive income.

Works cited

Is a Business Development Company Worth the Risk? | Charles Schwab, accessed November 5, 2025, https://www.schwab.com/learn/story/business-development-companies-high-yields-big-risks

Beyond the Yield: A New Investor’s Guide to Dividends