How to Avoid Yield Traps

Income investments can play an important role in a portfolio, but the headline yield is never enough information by itself. A high payout may look attractive, yet the real question is whether that income is sustainable and whether the investment’s value is holding up over time.

Most investors benefit from some combination of income and growth investments. Growth investments are designed primarily to increase in value; income investments are designed to pay cash through interest, dividends, or distributions. This article focuses on income investments and how to tell whether a promising yield is likely to meet expectations.

Investing means putting money into assets such as stocks, bonds, real estate, businesses, or funds with the expectation of profit or appreciation. Unlike saving, where principal is generally protected for short-term safety, investing involves calculated risk in pursuit of longer-term returns. The basic rule still applies: higher expected returns come with higher risk.

Many products are marketed as high-income investments even when the payout is unlikely to last. Some may pay unusually high distributions for a while, then reduce them. In worse cases, the income declines while the investment price also falls. That combination can turn an apparent income opportunity into a costly mistake.

Common income investments include:

• Bonds held to maturity, either individually or through fixed-maturity bond funds
• Real Estate Investment Trusts (REITs)
• Master Limited Partnerships (MLPs)
• Business Development Companies (BDCs)
• Structured income ETFs

Of these, bonds held to maturity are the closest to having a known outcome. If the issuer remains solvent and you hold to maturity, you generally know what interest you will receive and what principal will be repaid. This can be done with individual bonds or certain bond ETFs designed to mature on a set date. These tend to offer lower risk and, as of this writing, yields around 4% to 5% per year.

Other income investments may pay dividends or distributions, but the amount you receive when you eventually sell is not guaranteed. You may get back more than you invested, or less. That distinction is crucial.

An investment that pays out a large amount each month is not necessarily profitable if its value steadily shrinks. Imagine giving an advisor $10,000 in a bag of one hundred $100 bills. Each month, the advisor hands one bill back to you. After a year, you have received $1,200, which looks like a 12% return. But if the bag now contains only $8,800, you have not earned anything. You have merely received some of your own capital back.

This is not just hypothetical. One covered-call ETF went public in early 2024 at $204.20 per share, adjusted for a later reverse split. A $10,000 investment would have bought about 49 shares. In its first year, the fund paid $115.93 per share in distributions, more than 56% of the original investment. Later, it began making weekly distributions.

By late June 2026, investors had received $163.40 per share in distributions, nearly 81% of their original cost. That sounds impressive until the share price is considered. By then, the shares had fallen to $29.63, a drop of more than 86% from the adjusted starting price. And the weekly distributions were down to a relative trickle.

Here is the result per share:

• Distributions received: $163.40
• Sale price: $29.63
• Total cash realized: $193.03
• Original investment: $204.20
• Net loss per share: $11.17, or about $552 on a $10,000 investment

After all those dazzling distributions, the investor was worse off than if the money had simply been left in cash. The payouts looked like income, but much of the apparent return was offset by the collapse in share price.

This drop in the share price is known in the fund business as net asset value erosion, or NAV erosion.

This is an extreme example of NAV erosion, but it is real, and it illustrates the danger of a yield trap: an investment that attracts buyers with a high stated yield while eroding their capital.

The warning signs were visible:

• A quoted yield that seemed too good to be true
• No meaningful track record for a new fund
• A consistent decline in both share price and distribution amount

The lesson is simple: do not judge an income investment by yield alone. Look at whether the payout is covered, whether the share price or principal value is stable, and what the total return has been after both income and price changes. In a future article, we will focus on total return, the most important metric for avoiding yield traps.