For Financial Advisor and Current Client Use Only ...

[Pages:4]Yield: What is it? Why it matters--and why it's not the only factor behind returns

For Financial Advisor and Current Client Use Only

Marta Norton, CFA Investment Manager Morningstar Investment Services

Morningstar Investment Services Commentary

"What's the yield on that portfolio?"

It's one of the most common questions we receive. Yet, we often respond by touting the virtues of our total return approach, rather than reciting a portfolio's yield.

That's because while yield is important, we consider it just one facet of a fund's return. When building our portfolios, we look for a combination of capital appreciation and income to help drive returns. When that income is reinvested, and that capital compounds over time, good things can happen.

Definition of Yield Yield isn't the same thing as income. Rather, it's the amount of income you expect to receive divided by today's price (current yield) or the price at which you bought the security (cost yield). Another measure, yield-to-maturity, also takes into account the gap between the price you paid for the security and its face value.

All three measures vary depending on the price you pay for the security, as the following example illustrates using the example of a $1,000 face value U.S. Treasury bond that pays a 3.00% coupon rate annually.

Face Value Coupon

$1,000

3.00%

Purchase Price $1,000 $950 $1,050

Cost Yield

3.00% 3.16% 2.86%

Yield-toMaturity 3.00% 3.60% 2.43%

Of course, this is a simplified illustration. It doesn't take into account any call options (which are embedded in callable securities like mortgage-backed bonds) or transaction fees, and assumes the investor holds the bond until maturity. That aside, in all three cases, our annual income was the same: $30.

Where many investors err is in mistaking current yield for cost yield. For example, suppose the 3% coupon U.S. Treasury bond you bought for $950 is now trading for $900. The current yield on the bond has risen to 3.33% ($30 / $900 current price), but that's not the proper frame of reference. What matters is what you paid, making your 3.16% ($30 / $950) cost yield more representative of the amount of income your investment will yield over its lifetime.

Is Yield Important? We recently undertook a project to examine the correlation between current yields and subsequent total returns for bonds. Specifically, we compiled monthly snapshots of the Barclays Capital U.S. Aggregate Bond Index's yield-to-worst (a variant of yield-to-maturity that takes prepayment into account) going back more than three decades. We then compared those yields to the index's total return over the one-, three-, five-, seven-, and 10-year periods that followed the subject month.

Table 1

18% 16% 14% 12% 10%

8% 6% 4% 2% 0%

Yield to Worst

Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

Source: Barclays Bank PLC

Table 2

10-Year

Correlation

7-Year

0.90

0.95

5-Year 0.92

3-Year 0.80

1-Year 0.56

As shown in Table 1, we found that the index's yields were highly correlated with future returns over the long term. In other words, yield-to-worst tends to move in the same direction as the future returns of the index.

Our research also shows that income comprises the bulk of returns. Since 1976, for instance, the Barclays Capital U.S. Aggregate Bond Index's income return has accounted for 93% of its total returns, though that figure has fallen in recent years. Over shorter time periods, the income makes up significantly less of the total return. Since 2005, for example, income comprised just 57% of the index's returns, which is consistent with the lower correlations noted for shorter time periods. Time horizon and remaining invested are an essential part of earning the full total return.

What About Low Yields? With yields acting as a decent proxy for future returns, it stands to reason that the Barclays Capital U.S. Aggregate Bond Index's 1.73% yield-to-worst as of April 30, 2013 could mean the index's returns over the next five to seven years will come in well below recent levels of approximately 4% to 5% per annum.

Does this mean bond portfolios are destined to earn paltry returns for the foreseeable future? Not necessarily, for a few reasons:

First, extremely low-yielding U.S. government bonds, mainly Treasuries, account for almost 40% of the Barclays Capital U.S. Aggregate Bond Index. Yet, bond fund managers have more flexibility to seek higher-yielding opportunities outside of the government bond sector in areas like investment-grade and high-yield corporate bonds, mortgages and other assetbacked securities.

Second, the Barclays Capital U.S. Aggregate Bond Index consists of U.S. bonds denominated in the dollar. But investors need not sate themselves on such bonds, especially with some foreign bonds sporting more attractive yields and posing little incremental credit risk. Again, fixed-income fund managers have used their flexibility to seek attractive opportunities abroad.

Third, despite conventional wisdom, bond funds can benefit from rising rates. While bond prices can fall if interest rates rise, this decline is likely to be experienced in the short run. While the price of the bonds is declining due to rising rates, the income generated from

For Financial Advisor and Current Client Use Only

The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar Investment Services shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar Investment Services and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar Investment Services.

The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without notice, do not constitute investment advice and are provided solely for informational purposes. Morningstar Investment Services shall not be responsible for any trading decisions, damages, or other loses resulting from, or related to, the information data, analyses or opinions or their use.

The indices noted are unmanaged and cannot be directly invested in. Individual index performance is provided as a reference only. Since indices and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although index performance data is gathered from reliable sources, Morningstar Investment Services cannot guarantee its accuracy, completeness or reliability.

Definitions: Barclays Capital U.S. Aggregate Bond Index ? a benchmark index composed of US securities in Treasury, Government-Related, Corporate, and Securitized sectors. It includes securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.

Barclays Capital U.S. Corporate High Yield Index ? an unmanaged index that covers the universe of fixed-rate, noninvestment-grade debt.

newer-issued bonds is increasing, driving up the yield. Since we know yields can at times be correlated with bond returns, especially over five or more years, increasing bond yields should mean increasing bonds returns. Active management can add value here as fund skippers can control their exposure to bonds that may see prices rise/fall.

Why Not Only Look at Yield? As we have shown, yield levels can go far in predicting the direction of future returns of the Barclay's Aggregate returns. Nevertheless, they don't explain the entire return. While in the long term income comprises 90% of the return, investors likely wouldn't want to leave the remaining 10% on the table. Furthermore, over shorter periods, investors could miss out on a much higher total return if they focus only on income. Finally, we've limited our analysis to the Barclays Capital U.S. Aggregate Bond Index, but investors may find higher yields (and fatter coupons) by shifting into riskier investments. For example, the yield on the Barclays Capital U.S. Corporate High Yield Index is generally higher than the broad aggregate index. However, while the juicer yield might look attractive, it comes with a higher risk of downgrades or defaults, which could severely impair an investor's total return.

Conclusion Yields are undoubtedly an important part of a well-informed investment decision and we constantly monitor yield levels of various parts of the market. However, we don't use them in isolation. Price, coupon, and valuation are all important factors and can help investors earn better than index-like returns.

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