Yield Trap Definition
A Yield Trap is an investment that appears attractive because of its high dividend yield, but ultimately destroys investor wealth. The elevated yield is not driven by strong income generation, but by a declining share price reflecting underlying business deterioration.In such cases, income looks generous on paper while capital erosion overwhelms any cash received.How a Yield Trap Forms
- The company faces structural or cyclical challenges (declining earnings, rising debt, competitive pressure).
- The dividend is initially maintained, creating the illusion of stability.
- The share price falls sharply.
- Since yield = Dividend ÷ Price, the yield spikes — often into double digits.
- Income-focused investors are attracted by the apparent “bargain.”
- The price continues to fall, and the dividend is eventually cut or suspended, resulting in permanent capital loss.
Common Warning Signs
- Yield far above sector peers or the company’s historical average.
- Payout ratio exceeding 100% of earnings or free cash flow.
- Persistent revenue or earnings decline.
- High leverage or credit rating downgrades.
- Sector-wide history of dividend cuts.
Real-World Occurrences
Yield traps have frequently appeared in:
- Legacy telecoms and energy MLPs during the 2010s–2020s.
- Certain high-yield REITs or BDCs during economic downturns.
- Mature industries with shrinking demand (traditional retail, tobacco, etc.).
Why Income Investors Are Especially ExposedIncome-focused investors often screen securities by current yield alone. This leads them to buy just as the underlying business weakens further, mistaking a collapsing price for an opportunity rather than a warning.How to Avoid Yield Traps
- Never evaluate yield in isolation.
- Assess dividend sustainability (payout ratio ideally <80%, strong free cash flow coverage).
- Compare current yield to the company’s long-term average and sector peers.
- Monitor total return: a rising yield alongside a falling price is a major red flag.
- Favor businesses with stable or growing dividends, even at moderate yields.
Key Takeaway
A high yield is only valuable if it is sustainable.A temporarily elevated yield caused by a collapsing price is not true income — it is capital erosion disguised as cash flow.For long-term income investors, a reliable 6–8% yield from a healthy business is vastly superior to a 12% yield that steadily destroys principal.