Decoding Virtus Diversified Income & Convertible Fund's Distribution Strategy: Is the High Yield Sustainable?

The Virtus Diversified Income & Convertible Fund (ACV) has long captivated income-focused investors with its 14.4% yield (as of August 2025). However, the fund’s distribution strategy—reliant on a blend of return of capital, capital gains, and net investment income—raises critical questions about sustainability. To evaluate the risk-return profile of this high-yield closed-end fund (CEF), we must dissect its distribution sources and their implications for long-term viability.

The Illusion of Income: Return of Capital as a Double-Edged Sword

ACV’s August 2025 distribution of $0.18 per share was entirely sourced from net realized short-term capital gains [1]. Yet, the fund’s year-to-date (YTD) distribution breakdown reveals a stark reality: 64.1% of the $1.260 YTD distribution has been classified as return of capital, with 22.7% from short-term gains and 12.2% from long-term gains [1]. This pattern is not new. For instance, in May 2025, 100% of the distribution was return of capital, while April 2025 saw 61.1% return of capital [2].

Return of capital (ROC) is not taxable but reduces the investor’s cost basis in the fund. While this can create the illusion of a “high-yield” product, it effectively returns a portion of the investor’s principal. Over time, if ROC becomes the primary distribution source, the fund’s net asset value (NAV) will erode, potentially undermining its ability to sustain distributions. ACV’s NAV has already declined by 8.3% year-to-date (as of July 31, 2025), a trend that could accelerate if the fund continues to liquidate assets to meet its distribution target [1].

The Risk of Overreliance on Capital Gains

ACV’s reliance on capital gains—both short-term and long-term—adds another layer of risk. Short-term gains are taxed at ordinary income rates, which can be punitive for investors in higher tax brackets. For example, the August 2025 distribution’s 100% short-term gain allocation means shareholders will face full ordinary income tax liability on that $0.18 payment [1]. This contrasts with long-term capital gains, which are taxed at lower rates, and net investment income, which is typically taxed as qualified dividends.

The fund’s strategy of selling assets to generate gains is inherently volatile. Market conditions, interest rates, and sector performance can quickly shift the balance of gains and losses in the portfolio. If ACV’s investments face unrealized losses or if the fund’s leverage costs rise, the ability to sustain distributions through capital gains could falter.

Is the High Yield Sustainable? A Balancing Act

The fund’s Managed Distribution Plan aims to provide consistent income, but its execution hinges on a precarious balance. For the fiscal year-to-date, ACV has distributed more than its net investment income and capital gains (64.1% ROC + 22.7% short-term gains + 12.2% long-term gains = 98.9% of the $1.260 YTD distribution), leaving only 1.0% from actual income [1]. This suggests the fund is effectively returning nearly all of its gains and a portion of its principal to meet its distribution target.

Sustainability depends on two factors:
1. Portfolio Performance: Can ACV continue to generate sufficient capital gains to fund distributions without overliquidating its holdings?
2. Market Conditions: Will rising interest rates or sector-specific risks (e.g., in its convertible securities or high-yield debt holdings) erode the fund’s ability to realize gains?

Historically, ACV has managed to maintain its distribution by leveraging its active management of convertible securities and high-yield bonds. However, the increasing proportion of ROC in its distributions signals a growing reliance on principal returns rather than income generation. This trend could accelerate if the fund’s portfolio underperforms or if market volatility forces premature asset sales.

Conclusion: A High-Yield Mirage?

ACV’s 14.4% yield is enticing, but investors must recognize that a significant portion of this yield is not income but a return of their own capital. While ROC can provide tax advantages in the short term, it erodes the fund’s NAV and raises concerns about long-term sustainability. For risk-averse investors, this strategy may not align with the goal of preserving capital while generating income.

The fund’s ability to sustain its distribution hinges on its capacity to outperform market headwinds and maintain a steady flow of capital gains. However, in a rising-rate environment or during market downturns, the risk of distribution cuts or ROC-driven NAV compression becomes material. Investors should weigh these risks against the allure of high yields and consider diversifying their income portfolios with CEFs that prioritize income generation over capital return.

**Source:[1] Virtus Diversified Income & Convertible Fund Announces Distributions and Discloses Sources of Distribution – Section 19(a) Notice [https://www.businesswire.com/news/home/20250827835470/en/Virtus-Diversified-Income-Convertible-Fund-Announces-Distributions-and-Discloses-Sources-of-Distribution-Section-19a-Notice][2] Virtus Diversified Income & Convertible Fund news (Ticker: ACV) [https://www.stocktitan.net/news/ACV/]