Bond Yield vs. Return
Yield is the income that a fund pays on either a monthly or quarterly basis. You can either take this income in the form of a check or reinvest it into the fund to buy new shares. There are many ways to calculate yield, which confuses many people. The bottom line is that if a fund’s share price didn’t change, and it paid a 5% yield in a given year, the fund’s total return would be 5% for that year. The total return is a function of interest paid by the bonds held within the fund. It also includes any capital gains or losses on the bonds and any price appreciation of the fund portfolio. In a given year, changes in price, interest, losses, and gains can cause the total return to be higher or lower than the fund’s yield. The type of fund will dictate the degree of impact that these changes can have on a fund’s return. For instance, high-yield and emerging market bond funds tend to have much greater volatility than short-term bond funds that invest in higher-quality securities. So, before you invest in a fund, you should be sure that you know the level of risk and that you can withstand the volatility that a fund might have. A fund that invests in high-yield bonds tends to have a higher yield than a bond fund that invests in higher-quality securities. If you need the money soon or have a low-risk tolerance, the amount of principal fluctuation that higher-yield bonds have makes them a poor choice.
How Capital Gains Distributions Affect a Bond Fund’s Return
Each year, many bond funds pay out capital gains on the money they have made from buying and selling bonds. This is a complex issue, but there are some aspects you should keep in mind:
Capital gains result in a matched reduction in the fund’s share price (for instance, a fund with a $10 share price that pays a 20-cent distribution will see its share price drop to $9.80). Despite the drop in share price, the total return is unchanged because you’ve received a portion of the total value in a capital gains distribution. You can either reinvest the proceeds and buy more shares or take the distributions as income. Either way, if you hold a fund in a taxable account, you’ll have to pay taxes on the distribution. That means the total return after taxes will be reduced by the amount of tax you paid. The total returns quoted in the media and on the fund’s website assume that all dividends and capital gains are reinvested. Unless you need the money to pay bills, it’s best to reinvest distributions, since that allows more money to compound in your favor.
The Bottom Line
You should take care not to confuse yield with total return. Just because a fund has a reported yield of 7%, that doesn’t mean that’s the real return on your investment. In any given year, changes in the bond fund’s share price will vary. The fund’s capital gains distribution to its shareholders will change with respect to the changes. If your tax situation changes, your after-tax returns will likely change as well.
