It’s usually the first question that comes to an investor’s mind when considering an investment in a bond fund: What’s the yield?
Such a simple question. Such a complicated answer.
The simple answer to this question—and, most likely, the wrong answer—is the distribution yield published by the bond fund’s sponsor. While the distribution yield of a bond fund is certainly a “yield,” it can mislead more than inform and is often the only type of bond fund yield statistic redistributed by independent financial data providers.
The Shortcomings of Bond Fund Distribution Yields
Bond fund distribution yields typically take one of two forms:
- One approach involves dividing the most recent per-share distribution of the fund by the fund’s current per-share net asset value (NAV) and annualizing the resulting figure (i.e., multiplying it by 12 if the fund pays monthly distributions) to arrive at an annual distribution yield.
- The other approach entails dividing the sum of all of the per-share distributions of the fund over the past 12 months by the fund’s current per-share NAV to arrive at an annual distribution yield.
The problem with distribution yield statistics is that a variety of factors may cause them to overstate or understate the actual net earnings of a fund, often times by significant amounts. For example, many bond funds, particularly closed-end funds, employ “managed distribution policies,” which are commitments on the part of funds to make fixed minimum distributions regardless of whether they earn income equal to the amount of their distribution rate. Managed distribution policies produce distribution yields that overstate a fund’s income in cases where a portion of fund’s distribution constitutes return of capital rather than income.
Even if a fund follows a practice of distributing only income, distribution yields are typically presented on a per-share basis, which means changes in the number of shares outstanding over the course of a month will change a fund’s per-share distribution yield. Imagine a bond fund that receives a subscription for shares that doubles its shares outstanding on the day it makes its monthly distribution. The aggregate amount of income to distribute remains unchanged, but it now must be distributed to twice as many shares, cutting the per-share distribution in half. The original investors in this example would still earn the same total return, since the reduced per-share distribution would be equally offset by a higher per-share NAV, but the distribution yield of the fund would appear artificially low.
This process works in reverse for funds that are shrinking. A reduction in the number of shares outstanding over the course of the month will increase the per-share distribution rate. While the impact of changes in shares outstanding on per-share distribution rates will be small in very large funds, it can be significant in smaller funds that are growing or shrinking quickly.
Bond fund distribution yields are also easily manipulated, and active bond fund managers have historically engaged in a variety of tactics to game their stated distribution yields to make them appear higher than the fund’s actual income would suggest. Recognizing the shortcomings of bond fund distribution yields, the Securities and Exchange Commission took action in 1988 with the introduction of the 30-day SEC yield, a standardized yield calculation that all bond funds are required to calculate in the same manner.
Understanding the 30-Day SEC Yield
The 30-day SEC yield seeks to provide a measure of a fund’s earnings as of a recent 30-day period. While the taxable income of a bond fund, and therefore its distribution rate, is based on the purchase price it pays for its bonds, the 30-day SEC yield uses current market values as of the day of calculation to produce a hypothetical estimate of the interest earned, net of expenses, by a bond fund’s portfolio over the 30-day preceding period.
The 30-day SEC yield is hypothetical in the sense that it does not represent the actual earnings of a bond fund. Rather, a bond fund calculates what its current portfolio would earn in daily interest based on the current yield to maturity (YTM) of each of the bonds in the portfolio, regardless of whether the fund actually held all the bonds over the preceding 30 days. The YTM of an individual bond is a forward-looking estimate of how much an investor will earn from the bond assuming it is held to maturity and assuming all cash flows from the bond are reinvested at the YTM rate. In other words, the 30-day SEC yield employs a forward-looking estimate of income based on current market prices to calculate how much hypothetical income a bond fund would have earned over the prior 30 days had the fund held its current portfolio for the entire period.
In practice, the 30-day SEC yield of a bond fund tends to be pretty similar to the weighted average YTM of the fund’s portfolio, another statistic that many bond funds publish. Factors that may cause these two statistics to diverge include expenses and calleable bonds. While fund sponsors are required to calculate the 30-day SEC yield net of expenses, they frequently do not include expenses when they publish the average YTM of a fund’s portfolio. In the case of calleable bonds, the instructions on how to calculate the 30-day SEC yield require fund sponsors to make an assessment as to whether a bond is likely to be called before it matures and compute its expected YTM accordingly.
The Shortcomings of the 30-Day SEC Yield
While the 30-day SEC yield provides a way to compare bond fund yields on an apples-to-apples basis, it offers investors little insight into how traditional bond funds will perform going forward. At best, the 30-day SEC yield offers a reasonably accurate estimate of the income the traditional bond fund is currently earning.
The problem isn’t with the 30-day SEC yield. The problem is with the way bond funds have traditionally been structured. While an investor always has the option of holding an individual bond until it matures, traditional bond funds are designed to operate in perpetuity and have no maturity date. Therefore, investors wishing to liquidate an investment in a traditional bond fund must do so at the fund’s current NAV. Depending upon a variety of factors, including changes in the composition of the fund’s portfolio over time, the return an investor earns from an investment in a traditional bond fund can differ dramatically from the fund’s 30-day SEC yield at the time the investor made his investment in the fund.
Since traditional bond funds are designed to operate in perpetuity, they must constantly roll the proceeds of maturing and sold bonds into new bonds further out on the yield curve. The impact of the addition of these new longer-term bonds over time is not accounted for by the 30-day SEC yield. Moreover, bond funds frequently sell bonds before they mature at prevailing market prices, which can cause the return on the fund’s investment in the bond to differ materially from the YTM of the bond at the time an investor purchased shares in the bond fund.
Because of the deficiencies noted above, the 30-day SEC yield fails to provide a reliable estimate of the return an investor can expect to receive from an investment in a traditional bond fund. Only recently has a new type of bond fund been developed that permits investors to reasonably model their expected returns.
Target maturity bond funds, such as those that track NASDAQ BulletShares® Indexes, seek to address the shortcomings of traditional bond funds by adopting structural features that permit them to behave more like individual bonds. First, unlike traditional bond funds, target maturity bond funds have termination dates upon which they liquidate and return all investment capital to investors. Second, target maturity bond funds hold only bonds that mature in a particular year and generally hold them until they mature.
Because of the structural features of target maturity bond funds, the 30-day SEC yield serves as a reasonable starting point for modeling the expected returns from an investment in such funds. Just as with individual bonds, however, certain risks (including reinvestment risk, credit risk and prepayment risk) will cause the actual return an investor earns from a target maturity bond fund to deviate from the 30-day SEC yield of the fund at the time the investor purchases it.
While no investment product can provide certainty, target maturity bond funds represent an improvement over traditional bond funds in permitting investors to develop reasonable expectations about future performance. Investors have responded by pouring more than $7 billion into target maturity bond funds in the past five years. We anticipate that this number will continue to grow as investors seek protection from rising rates with products that offer a true fixed income experience.