A 12.31% dividend yield! Is this passive income gem too good to be true?

The UK base rate is currently set at 4.5%. The average dividend yield for the FTSE 100 is 3.57%. So when I spotted an investment trust with a yield of 12.31%, it naturally caught my attention.

For passive income hunters, the potential here could be huge, but warrants further inspection before making a call.

Investing in the debt space

The trust I’m referring to is the Chenavari Toro Income Fund (NASDAQMUTFUND:TORO). Chenavari Credit Partners manages the fund, which has a primary objective of delivering attractive, risk-adjusted returns by investing in structured credit markets and asset-backed transactions.

This might sound like a lot of jargon, so let’s break it down. The company buys and sells asset-backed securities and loans that have associated collateral. A mortgage is a good example of what would fit into this category. The same is the case for car finance, or any loan that’s taken out with some collateral against it.

Chenavari tries to make money by exploiting market inefficiencies in these loan markets. For example, the interest rate charged on a loan might be very attractive relative to the amount of risk involved, leading the fund manager to buy the loan.

Even though this might seem like a complicated strategy, it clearly works for the business. The annualised performance since inception in 2008 is 7.1%. The share price is up 2% over the last year. Even though the share price should track the fund’s net asset value (NAV), this isn’t always the case in the short term. Right now, the share price trades at a 26% discount to the latest NAV figure provided.

Dividend details

Usually, a really high dividend yield is caused by the share price rapidly falling. In this case, it pumps up the yield, but it’s not sustainable, as often the company has troubles that later cause the dividend to be cut.

For Chnavari, that isn’t the case, which is a good thing. In the latest annual report, the dividend policy was disclosed that it “targets a quarterly dividend yield of 2.5% (by reference to NAV) equating to a targeted annualised dividend yield of 10% (by reference to NAV)“.

Given that this target of 10% is close to the current yield, I don’t feel it’s unsustainable to remain around this level. This depends on company profitability. If the fund underperforms and profits dry up, the dividend must be reduced to preserve cash flow.

Aside from this risk, the other one to note is the illiquid nature of some of the products being traded. What I mean is that some of deals are private asset-backed finance. It’s not easy to sell these loans to other people quickly. So if there’s an urgent need for the fund to raise cash, it might struggle to do so in a smooth fashion.

The bottom line

I accept this is a niche stock for passive income that some investors won’t feel comfortable with. However, from the income side, I believe it’s a great option. For those with a high risk tolerance, it could be worth considering.

The post A 12.31% dividend yield! Is this passive income gem too good to be true? appeared first on The Motley Fool UK.

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Jon Smith has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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