What Danger Lurks Behind a Bond Fund's Yield?

One of the first lessons of basic accounting is usually about the three financials reports that paint the picture of a company's financial health: the income statement, balance sheet, and statement of cash flows. When you put them together, you know if a company's healthy or unhealthy and in which direction it's headed.

Examined individually, however, these statements can each lead to off-track diagnoses. Unfortunately, that's exactly what bond-fund investors do when they focus on yield to the exclusion of other important statistics. A bond or bond fund's yield, prominently quoted as a percentage, tells how much income one share has thrown off in a previous time period. Investors are naturally inclined to assume that higher yields mean higher income and total return going forward, and some bond-fund managers are quick to push this stat when they know theirs is above-average. But it is dangerous if it lacks context.

We'll examine why it's a mistake to focus exclusively on yield, but first, let's look at what exactly "yield" means for bond funds.

Two Different Types of Yield
Fund company literature usually focuses on a fund's "30-day" yield, also called its SEC yield. SEC yield is a standardized calculation based on the most recent thirty day period covered by the fund's filings and includes dividends and interest minus accrued expenses. The figure is annualized.

There's also the trailing 12-month yield, found on each bond fund's home page on Morningstar.com. This stat portrays a fund's total yield over the past year. To calculate the 12-month yield for a fund, we add up the last 12 monthly dividends, divide by the NAV, and also account for any capital gains distributions. To see how a fund's yield compared with its category rivals over the past year, you can visit any bond fund's Snapshot page on Morningstar.com and click on the "i" next to Yield in the Key Stats section.

The trailing 12-month yield offers a more accurate picture than SEC yield of a fund's income over the past year because it accounts for 12 distinct dividend payments, not just a recent 30-day period. In that sense, it matters: You want the most accurate picture of a fund's past income production before making decisions. But as we often point out in our research for each of the hundreds of bond funds we actively cover--available to Morningstar.com Premium Members--educated bond-fund-picking considers yield as just one piece in a larger puzzle.

The First Risk to Picking Based on Yield
Picking a fund just for its yield has two big risks. The first, bigger risk is that a bond fund offering a juicier yield than its typical category rival often carries more credit risk. For investment-grade funds that usually means above-average stakes in A or BBB bonds, while for high-yield funds it usually means above-average stakes in bonds rated CCC or below. If you're worried about the credibility of bond rating agencies' evaluations, given some of the negative press lately, keep in mind that bond-fund managers usually rate each bond with an internal rating, too. The internal and external ratings match most of the time, but in rare instances they can differ.

At just about any point in bond-funds' history you can find those whose yield looked deceptively good, only to be hiding serious risk. Such instances usually come to light when investors are concerned about the economy's outlook and so they sell lower-rated bonds, and today two recent examples fit the mold.  Oppenheimer CA Municipal (OPCAX) competes in our muni California long category. Its trailing 12-month yield of 5.73% is tops in its group, and one year ago it offered an above-average yield and a great three-year return. Its riskier holdings had rallied for several years, helping the fund to a 5-star rating. But since then, it has been a slippery slope. It lost almost 14% in the year ended May 27. Oppenheimer's managers argue that the credit stability of its underlying holdings is still intact and that market technical forces are to blame, but only time will tell. Then there's intermediate-bond fund  Regions Morgan Keegan Select Intermediate Bond . Its trailing 12-month yield is badly inflated because it has lost so much principal (as reflected by its NAV decline). In mid-2007, an above-average yield owing to risky mortgage investments had boosted its returns. But with mortgage bonds' collapse, this fund's holdings went south and it lost 50.3% for the year. Its woes continue to this day.

The Second Risk
If that weren't enough, the other risk of yield is that it draws investors' eyes away from a more accurate predictor of a fund's future success or failure: expenses. Morningstar studies have reinforced our assertion that expenses are a critically important factor in picking a bond fund, especially in investment-grade categories. The range of returns between huge winners and huge losers in these categories is often a couple of percentage points, at best, in any calendar year. In the case of two funds with equivalent manager skill, credit risk, and sensitivity to interest-rate movements, the fund with lower expenses produces higher total return every time. Similarly, a management team that has a low-expense tail wind can take less credit risk if they believe the economic outlook is uncertain, while still delivering yield comparable to riskier rivals. (Expenses are deducted from yield.)

Closing Thoughts
Morningstar mutual fund analysts consider these factors and look well beyond just yield when evaluating a bond fund. Our Analyst Picks--a great place to start if you're looking for a solid bond fund--are a collection of funds managed by experienced, proven teams. They typically offer below-average expenses and a shareholder-friendly culture at the asset manager firm.

Finally, we aren't against credit risk just for conservatism's sake, and we have designated picks in the high-yield bond and high-yield muni categories, too. We have picked these funds because we're confident that their managers can deliver a nice yield while avoiding many of the traps inherent in below-investment-grade bonds.  T. Rowe Price High-Yield (PRHYX) is one of our favorites, but there are plenty of others to choose from as well. As always, remember to limit high-yield exposure to a modest slice of your overall bond portfolio.