When the Numbers Lie

Jason’s Observation

In July, The Wall Street Journal's Jason Zweig published "Don't Believe the Inflated Yields on Inflation-Adjusted Bond Funds." The article discussed how some inflation-protected bond funds (to use Morningstar's name for the category) boast 30-day SEC yields that exceeded 7%, while others report piddling amounts. (Note: This condition applies both to mutual funds and to their younger siblings, exchange-traded funds.)

Such disparity would be strange for any fund category. It is especially odd for inflation-protected bond funds, which generally look much alike. Although some funds take a different path by owning corporate securities or using derivatives, most invest primarily in Treasury Inflation-Protected Securities, or TIPS. For that reason, their performances tend to be similar. So far this year, for example, 85% of inflation-protected bond funds have gained between 3% and 5%.

How could yields be so diffuse while total returns are so clustered? Zweig provides the answer. When making the SEC’s 30-day yield calculation for inflation-protected bond funds, fund organizations “take dividends and interest earned per share during the prior 30 days, deduct expenses and annualize it. The SEC’s rules for calculating its yield, however, don’t say whether to include the inflation adjustment or leave it out. And that gives funds a lot of leeway.”

Yes, it does.

Interest and Principal

To explain: TIPS deliver two sources of return. One is their stated yields, and the other is the amount by which their principal adjusts in response to inflation. The stated yield, which is typically low, is paid semiannually. In contrast, the principal adjustment, which makes up the larger part of TIPS’ expected returns, is not distributed until its maturity date. Consequently, inflation-protected bond funds don’t pay much income. When measured by actual cash outlays, the median trailing 12-month distribution for an inflation-protected bond fund is 2.24%.

If the inflation rate is positive, as is typically the case, the stated yield on TIPS understates their expected returns. That differentiates TIPS from other forms of Treasuries. With conventional Treasuries, the return to a buy-and-hold investor is the bond’s stated yield. (We’ll set aside the issue of reinvestment rates.) With TIPS, though, stated yield is less than half the story. One could therefore argue that, by considering inflation’s effect on a TIPS’ principal, the 30-day SEC yield calculation places TIPS on an equal footing with other government securities.

Three Concerns

Except ... there are three difficulties. One has already been mentioned: The principal adjustment consists of phantom yield, not an actual payment. (Regrettably for investors, the IRS treats the adjustment as immediate income, when it is in fact a deferred capital gain. Pay taxes today, receive the profit tomorrow.) That conflicts with the purpose of the yield calculation, which exists not to estimate a fund’s future total returns but instead to provide investors with a sense of what the fund is currently distributing. At that task, it fails.

A second headache is that the statistic fluctuates widely. The monthly change in the Consumer Price Index was 0.1% in October 2020, 0.4% in February 2021, and 0.9% in June. Such movements far exceed the changes in the underlying trend of inflation, which is why economists study core inflation rates and over longer time periods. Modifying the 30-day SEC yield calculation to include the annualized effect of these monthly blips makes the output highly unstable.

Finally--and worst of all--the numbers lie. Technically, they are correct, as the SEC permits the inflation adjustment. What's more, as I previously wrote, that inclusion can at least partially be justified, as doing so levels the playing field between TIPS and Treasuries. When I evaluate the relatively attractiveness of TIPS, I mentally sum their stated yield plus their projected inflation adjustment. There's nothing wrong with using such information.

However, while adding the inflation adjustment to the stated yield can be helpful, doing so is actively harmful when it eliminates comparability. With total return, one fund’s statistic may be directly compared with another’s. Unambiguously, a 9% total return is 50 basis points above an 8.50% return. The same principle applies to expense ratios, net assets, and portfolio holdings, along with most other fund-company data. But not to 30-day SEC yields. The measure misleads.

Less Is More

The solution, of course, is to settle on a single method. Either have all inflation-protected funds supplement their stated yields by including the effect of the principal adjustment, or none of them. Zweig prefers the second option, writing “funds that claim to be protecting against inflation should protect their investors against inflated expectations, too.” That approach is indeed preferable. However, for all its faults, adjusting for inflation would also suffice, were that to become the standard. What matters is comparability. Without that attribute, all approaches fail.

The SEC could easily fix the problem. The commission merely needs to add one line to its regulations, prohibiting changes in TIPS' principal from being used in the 30-day yield calculation. (Or, less attractively, it could mandate their inclusion.) Only ... that fix doesn't appear to be so easy. This mess has existed for a long time now. So long that Zweig wrote a similar column in April 2011.

The SEC is not the only guilty party. The fund industry could have eliminated the confusion, but it has not. Frequently, the fund industry evolves and improves in response to customer demand. But such actions tend to be individual; one firm sees an opportunity and reacts accordingly. That is a different mechanism for creating change than is required to solve this problem, which involves working together to reach a common goal.

Nor should fund researchers be absolved. Morningstar has had more than a decade with which to nudge the SEC into making the desired edit. Failing that, Morningstar could-- and should--mandate its own standard, informing fund organizations that if they do not comply with its request, Morningstar will not publish their submitted figures. Better to leave a data field blank than to publish misleading figures.

I will push this issue internally in the hopes that a solution will be forthcoming. Until then, caveat emptor with inflation-protected funds’ 30-day SEC yields.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.