Bond fund yields: what investors need to know
Interest rates have been on the rise, shifting the bond market away from the low-yield environment that had been in place since the financial crisis. These rising yields weighed on fixed-income performance in 2022—leading to historic outflows from bond funds—but there are signs that higher yields have begun to lure investors back to the asset class. Here’s what investors should know about how a bond fund’s yield is measured.
What does a bond fund's yield tell you?
A bond fund’s yield can give you a sense of how much income the fund has recently produced or may produce in the future. But there are different ways to calculate yield that are important to understand. Some methods, like a fund’s SEC yield and its distribution yield, are backward-looking metrics; others, like yield to maturity (YTM) and yield to worst (YTW) are forward-looking assessments. Each of these yield calculations offers insight into a fund’s income-producing potential, but it’s important to know the benefits and limitations of each before you make any yield-based investment decisions.
What is SEC yield?
All funds that report yield information to the U.S. Securities and Exchange Commission (SEC) are required to calculate the 30-day SEC yield. This measure provides an estimate of the yield an investor would receive in a year, net of expenses. The calculation is based on the dividends and interest received in the prior 30-day period and assumes that all bonds are held to maturity and that income is reinvested.
Since the formula is both standardized and required, this metric is an easy way to compare funds to one another. Assuming that all bonds are held to maturity also accounts for any holdings that might be trading at a premium or discount. However, the metric can quickly become stale since it only considers the most recent 30-day timeframe. Investors who are using this metric to compare funds should ensure they’re using information from the same as-of date to make the most accurate comparison.
What is distribution yield?
Distribution yield is another commonly used measurement. At a basic level, distribution yield sums the fund’s actual cash flows per share and divides this total by the fund’s price or net asset value per share.
Unlike SEC yield, there is no standardized format for this metric; it can be calculated in several ways. One fund might sum the prior 12 monthly distributions, while another might multiply the prior month’s distribution by 12 to get an annual estimate. Since this measurement can include any cash flow received by shareholders, it might also include single payments such as a capital gains distribution, which can skew the measure.
One advantage of distribution yield, particularly when calculated using 12 distinct payments, is that the metric reflects a fund’s performance across a longer range of time using the actual cash flows received. But since it’s backward-looking, the metric can lag in rising rate environments and overstate yield when rates are falling. Investors using distribution yield to assess a fund should be aware of what’s included within the calculation, particularly when using this measure to compare funds.
Forward-looking measurements: yield to maturity vs. yield to worst
YTM calculates the weighted average total yield of the fund’s holdings, assuming that all interest payments are received from the date of purchase until the bonds reach maturity. The calculation also assumes that these payments are reinvested at the same rate as the original bond. YTM and SEC yield are often similar due to how they’re calculated, though YTM doesn’t account for fund expenses.
YTW is similar to YTM, but rather than assuming all bonds are held until maturity, YTW is an estimate of the lowest possible yield that can be received without experiencing a bond default. Some bonds include provisions that allow the investment to be called before maturity, shortening the holding period and, in turn, the amount of interest income received.
It’s important to note the assumptions built into these metrics. Bond funds, especially active ones, typically don’t hold their investments through maturity. It’s also unlikely that all interest income received will be reinvested at the same rate, as market conditions are always changing. Despite these assumptions, these metrics can be useful as they’re forward-looking assessments rather than a measure of the past.
Different measures can lead to different results
Due to the differences in how each is calculated, there can be meaningful variances between each yield measurement even when calculated for the same portfolio at the same time. Consider the three hypothetical funds below:
|Fund A||Fund B||Fund C|
For illustrative purposes only. Not indicative of any specific fund.
Depending on the yield metric used, different investors might come to different conclusions on which fund has the highest yield among the three. Fund A appears to have the highest SEC yield while Fund B has the highest YTW. Fund C’s distribution yield is significantly higher than the other two funds, possibly due to a difference in how this metric has been calculated for each. This example underscores the importance of using the same yield measurement when comparing funds and understanding what’s included within the calculation.
Yield is only one piece of the fixed-income puzzle
While each of these yield metrics can be a useful tool in the investment selection process, it’s important to remember that yield should be one data point of many used to evaluate a fixed-income investment. Other important factors to consider might include the investment scope of a fund, the potential drawdown for the investments included within a fund, and how a fund’s return correlates with other investments within an investor’s portfolio. Considering yield as just one data point among many used within a comprehensive due diligence process can help ensure investors are making prudent decisions when selecting fixed-income funds for their portfolios.
This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. No forecasts are guaranteed. Any economic or market performance is historical and is not indicative of future results.
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