This may be the most commonly asked, and often the only asked, question posed by those choosing a bond fund. Decisions based solely on yield, however, may be shortsighted at best. Investors need to gain an initial understanding of the various types of yields and their respective total returns before jumping on to the bond playing field.
When most people mention yield, they are referring to current yield, i.e., the current annual interest income divided by the initial price paid for the investment. For example, a $1,000 bond paying a hypothetical 6% interest, or $60 a year, which was purchased for $1,020 carries a current yield of 5.9% ($60/$1020).
A better measure is yield to maturity. It is more complex than the basic calculation of current yield, but it is also the most complete measurement of performance, taking into account the present value of future interest payments. Total return includes reinvested dividends, along with any capital gains or losses.
Several factors can affect yield and total return. One important consideration is credit rating; lower quality issues tend to pay higher yields to compensate for added risk. Some funds have a majority of the portfolio invested in the highest rated bonds, and although those funds may not have the highest yields in the marketplace, they may perform very well in terms of total return over a meaningful period of time. For bonds carrying similar credit ratings, the longer the time until maturity, the higher the yield tends to be, though some professionals believe this is only true in an upward sloping or “normal” yield curve.
Many investors who understand yield still have a difficult time comparing the performance of bond funds accurately in a marketplace where mutual fund companies calculate and advertise yields in different ways. Some funds declare dividends daily based on income that has accrued at the close of each business day, with dividends paid at month’s end. Other funds declare daily dividends based on projections of estimated net income. Still others declare dividends monthly in amounts that are not necessarily the same as the actual income.
Since most yield calculations are based on past earnings, they may not precisely reflect the performance of the fund’s current portfolio, making projections of how the portfolio will perform difficult. When individuals buy managed funds, they must recognize they’re also buying the resources of the fund’s sponsor, including in-house credit research capabilities. An investor needs to determine the track record of the fund manager, the amount of risk in the portfolio, and the durability of the yield.
The Securities and Exchange Commission (SEC) has established an industry standard for computing yield in mutual fund advertisements and sales literature. The standard creates a fixed-yield quote requirement for bond mutual funds, making it easier for investors to decide which bond funds are most suitable for their investment portfolios. In addition, investors are encouraged to consult a prospectus for a complete list and description of its bond holdings.
Bond funds can be a valuable addition to any portfolio. However, before investing, be sure that bonds are consistent with your overall financial objectives.