EnvisionCap.com: Forbes Article - Bond Yields and Other Myths

Bond Yields and Other Myths

Marilyn Cohen, Forbes Magazine, 08.08.97

SUPPOSE YOU ARE INTERESTED in buying into the Lord Abbett U.S. Government Securities Fund. What's the yield? If you call the fund up and ask for the yield, you are told that it is just under 5%.

But if you look in Forbes' bond fund tables you will see that the fund's A shares pay about 8% a year in income dividends. This number is the "distributed yield." It's equal to income dividends over the past 12 months, divided by current net asset value.

The smaller number is what the industry calls the SEC yield. The Securities & Exchange Commission has decreed a formula for calculating yields that is designed to prevent funds from concocting artificial, unsustainable payouts and advertising them as if they were a measure of return from a portfolio.

The SEC yield is computed from the yields to maturity of a portfolio's bonds over the past 30 days, adjusted for expenses. It is based on the fund's offering price, which includes the sales load, if there is one. The monthly computation is then annualized.

Why would payouts be so different from SEC yields? Apart from the effect of the sales load, there is frequently one big reason for the discrepancy: premium bonds. A fund that wants to pay out fat income checks can stock up on high-coupon bonds. Their current payouts are higher than their yields to maturity.

The 10.75% Treasury of 2005, for example, trades at 128. Buy one at that price and you can kid yourself that the bond is "yielding" 8.4% (coupon of 10.75% divided by 128). But when the bond matures in 2005, you've got a principal loss of 28 points. The current yield is 8.4%, but the yield to maturity on this bond is only 6.25%. The yield to maturity takes into account bond-premium erosion.

The Lord Abbett fund is an extreme example of the gap between the two modes of measurement, but it's not the only one. Morningstar figures that there are 191 bond funds whose distributed yields differ by a percentage point or more from the SEC yields.

Government bond funds are not the only ones buying premium bonds. They also show up in high-yield and emerging markets portfolios. Take the Salomon Brothers Strategic Bond Fund A, a collection of emerging market-debt, high-yield, foreign-currency and investment-grade bonds. The distributed yield is 8.6%, the SEC yield 6.1%.

There are 191 bond funds whose distributed yields differ by a percentage point or more from the SEC yields.

My advice: Stay with the SEC number.

But I will go a step further and warn investors in bond funds that even the SEC yield does not show the whole picture. It does not take inflation into account. If you spend all the income from a bond fund you will actually be drawing down capital, since both the final value of the fund and its stream of dividends are losing purchasing power to inflation;even at today's relatively modest inflation rate of 2.5% or so.

So, if the fund has an SEC yield of 6%, the prudent investor will adjust that down to 3.5%. It gets even worse if you factor in income taxes but I am assuming that you either are retired and taxed at a low bracket or keep the money in a tax-deferred account. (If you are in a high tax bracket it doesn't make much sense to own a long-term bond fund at all, unless you are more optimistic than I am about interest rates.)

At any rate, never, but never, buy a bond fund on published yield alone. If you have $100,000 or more to invest, consider being your own bond-fund manager. Put a fourth of your money in each of four Treasury notes, due three, five, seven and nine years out. As each note matures, replace it with a new nine-year note. The ladder's average maturity will stay in the range of three to six years. And yet, if interest rates stay constant, your yield over time will rise to the rate on the nine-year Treasury, currently 6.3%. That's a real 6.3%;no management charges, no hidden premiums.

You can't beat the expense ratio on a home-made Treasury fund. Figuring you lose $200 in commissions and markups every time a $20,000 bond matures and must be replaced, you're spending only $40 a year, which is a minuscule four basis points. Not even Vanguard can run a bond fund that cheaply.

I hate to make your life difficult, but buying a bond fund is a lot more complicated than the fund sponsors make it seem. And creating your own bond fund is a lot easier than you may think.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.