A fund's yield measures how much the fund is currently paying in dividends; it is quoted as a percentage of the fund's share price: say, 6.4 percent. This statistic certainly seems like a valid one for comparing funds. Unfortunately, it has been abusively exploited by some fund companies.
Don't confuse a bond fund's yield with its return. Dividends are just one part of a fund's return, which includes capital gain distributions as well as changes in the bond fund's share price. Over a given period of time, a bond fund could have a positive yield but a negative overall return.
Some unscrupulous fund companies try to obscure the difference between yield and return. Forbes magazine once reported on an advertisement sent out by the Fundamental U.S. Government Strategic Income Fund. In huge type on the cover of this brochure, the fund boasted of its 11.66 percent yield, an impressive number because the 30-year Treasury bonds were yielding less than 8 percent at the time. One can only assume that the designers of this promo piece hoped that you wouldn't check out the back cover, where the small print stated that the fund's overall return for the previous year was negative 15.7 percent.
Bond funds and the mutual fund companies that sell them can play more than a few games of creative accounting to fatten a fund's yield. Such sleight of hand makes a fund's marketing and advertising departments happy because higher yields make hawking the bond funds easier for the salespeople. But always remember that yield-enhancing shenanigans can leave you poorer. Here's what to watch out for:
Lower quality. You may compare one short-term bond fund to another and discover that one pays 0.5 percent more and therefore looks better. However, if you look a little further, you discover that the higher-yielding fund invests 20 percent of its assets in junk bonds (a BB or less credit-quality rating), whereas the other fund is fully invested in high-quality bonds (AAA and AA rated). In other words, the junk bond fund is not necessarily better; given the risk it's taking, it should be yielding more.
v0 Lengthened maturities. Bond funds can usually increase their yield just by increasing maturity a bit. (Insiders call this gambit going further out on the yield curve.) So when comparing yields on different bond funds, be sure that you're comparing them for funds of similar maturity. Even if they both call themselves "intermediate-term," if one bond fund invests in bonds maturing on average in seven years, while another fund is at ten years for its average maturity, comparing the two is a classic case of comparing apples to oranges. Because longer-term bonds usually have higher yields (due to increased risk), the ten year average maturity fund should yield more than the seven year average maturity fund.
v0 Giving your money back without your knowledge. Some funds return a portion of your principal in the form of dividends. This move artificially pumps up a fund's yield but depresses its total return. Investors in this type of bond fund are rudely awakened when, after enjoying a healthy yield for a period of time, they examine the share price of their bond fund shares and find that they are worth less than they paid for them.
When you compare bond funds to each other by using the information in the prospectuses, make sure that you compare their total return over time (in addition to making sure that the funds have comparable portfolios of bonds and durations).
u0 Waiving of expenses. Some bond funds, particularly newer ones, waive a portion or even all their operating expenses to temporarily inflate the fund's yield. Yes, you can invest in a fund that is having a sale on its operating fees, but you also buy yourself the bother of having to monitor the fund to determine when the sale is over. Bond funds engaging in this practice often end sales quietly when the bond market is doing well. Don't forget that if you sell a bond fund (held outside of a retirement account) that has appreciated in value, you owe taxes on your profits.
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