The yield trap
Bond yields depend on the purchase price, the yield at the time of purchase, and the sale price. The rest is mathematical. Unfortunately, investors often have a hard time figuring out which âreturnâ to use when trying to compare investments. There are a lot of them, and using the wrong output can give disappointing results.
Jason Zweig’s recent the Wall Street newspaper article, High rates? Are you delusional?, brought back many memories of my brokerage days in the 1980s and 1990s. Zweig called investors crazy if they think their bond fund is producing a big return, while comparable funds struggle in a low interest rate environment.
As Zweig explains, this happens because investors often look at the “distribution yield” rather than the “SEC yield”. The distribution return may include a return of the fund’s principal, while the SEC return reflects only net interest earned. When a fund distributes 10% of its net asset value (NAV), it is not interest income. It is your own money that comes back to you.
This misunderstanding of distribution performance reminded me of an old selling trick that brokers play to sell bonds to less sophisticated individual investors. They cite a bond’s coupon rate rather than the yield, or they cite its âcurrent yield,â which is the bond’s coupon rate divided by its current price. Both of these methods are discouraged by the Security and Exchange Commission (SEC) because they can dramatically inflate revenue expectations.
Here is an example:
A new issue, at 10 years, rated AA and non-redeemable, has a coupon of 5%. This means that he pays $ 50 interest annually for every $ 1,000 of face value. Since interest rates are currently below 5%, the bond is offered at a price plus 121 (which means 121% of its face value). Here’s how three brokers represent that connection to clients.
- A broker calls a potential client who is not sophisticated. The broker only explains that the non-redeemable bond will pay 5% interest per year for 10 years and the bond price is 121.
- A second broker calls the same prospect and explains that the non-redeemable bond will pay 5% interest per year for 10 years, the price of the bond is 121, which means the current yield is 4.1% (5% divided by 121).
- A third broker calls the same prospect and explains that the non-callable bond will pay 5% interest per year for 10 years, the bond’s price is 121, and it matures at 100, which means that the yield to maturity is 3.0 percent.
After hearing these three offers of exactly the same bond at the same price, the potential client calls back Broker # 1 and purchases $ 100,000 of the new issue. Why? Because the information withheld by broker # 1 confused the client.
The client thought he heard, âYou can get 5.0% from me, 4.1% from broker # 2, or 3.0% from broker # 3. Which do you prefer? âWe all know that’s not what the brokers actually said, but when a person doesn’t know the difference between coupons and returns, it’s easy to manipulate them.
Broker # 1 got the deal because he didn’t indicate the right return. It was highly unethical and bordering on illegality. I have watched this happen everyday as a broker and am sure it still happens today.
The SEC requires that individual bonds be quoted at worst yield. This means that brokers should offer the lowest possible yield the client can earn, assuming the bond matures or is called. It is acceptable to quote yield to maturity when the worst-case yield is the same as the yield to maturity. So in the example given, broker # 3 correctly indicated 3.0% as the yield to maturity of the bond.
There are many different returns. Here are two that investors should know:
- Individual bond buyers use Performance at worst (YTW): This is an SEC return required for the listing of non-redeemable and redeemable bonds. It’s your best factor for comparing bond yields with similar credit ratings, maturities, and buying characteristics. If the yield to maturity is shown instead of YTW, it is YTW.
- Mutual fund buyers use SEC yield: Also known as the standardized return, this figure reflects dividends and interest earned in the most recent 30-day period, after deducting fund expenses. Interest earned does not necessarily mean interest paid. This figure is based on the fund’s regular deposits with the SEC.
These two returns will cover most of the bond buying needs. They will help compare the opportunities between bonds and funds of similar characteristics. Remember this and you will be wiser about it.
Common sense also helps in comparing fixed income investments. If a bond or bond fund is earning well above its category average, then assume something is wrong. Either you are looking at the wrong metric or there is a huge risk that you are not taking it into account.
Bond investing is not difficult. Let’s just assume that you are going to find the same return as everyone else. Avoid fantastic performance âdealsâ because they are the ones causing the problems. You can find a good deal if the return is a little higher than average, but more and you’re probably missing out on something important.