There's More to Investing Than Yield

These days, income-oriented investors are a lot like the proverbial man in the desert, who is thirsty but short on water. Yields are generally pretty paltry, especially among safer investments like government bonds. Stock investors have felt the pain too, as the recession has forced many companies to slash or eliminate their dividends.

To be sure, income-focused investors are pursuing a reasonable strategy. Historically, dividends have accounted for at least 30% of the S&P 500 Index's average 10% annual return. And in a slower-growth environment, they could play an even bigger role. Income also provides stability to a portfolio--a benefit both equity and fixed-income investors can enjoy.

But are investors making a mistake by obsessing over yields? To answer that question, let's first take a look at what yield actually is and a couple different ways of measuring it. Lastly, I'll explain why yield shouldn't be the only thing income-oriented investors care about.

What is yield?
Simply put, yield measures the amount of income an investment or portfolio of investments pays out over a given period. For instance, if a bond that's worth $1,000 pays $100 a year in interest, the yield would clock in at 10%.

Many investors make the mistake of equating yield with total return. Yield is only one component of total return. The other is capital appreciation, or changes in the market price of an investment. As an example, let's return to the bond valued at $1,000 with a 10% yield. If the bond's price doesn't change while you own it, you'd earn a 10% return. But suppose investors become especially bullish on the bond issuers' prospects and push the price of the bond to $1,050. Your total return would include not just the yield but also the 5% increase in the price of the bond. The opposite is true too. If the market soured on the bond, its return will be less than 10%--you'd still pocket that fat yield but your principal value would decline.

What's the best way to measure yield?
You'll find yield is expressed in one of two ways. The first is the trailing 12-month yield, which measures the total amount of income a stock or a fund has paid out over the past year. That's what you'll see on Morningstar.com. Another common measure, which is used for bond funds, is the 30-day yield, or SEC yield. The SEC-mandated formula is a little complicated, but as its name suggests, it's a once-monthly measure of a portfolio's yield over the preceding 30 days. You'll find the 30-day SEC yield on most fund company Web sites (though Morningstar.com Premium Members can use the  Premium Fund Screener to search for funds based on SEC yield).

Neither measure is perfect, but the SEC yield offers a better reflection of a fund's current yield. The 12-month number has the virtue of reflecting a longer time period, but it's also backward-looking. A stock may have a plump yield, but if the company is financially trouble, it might not be able to sustain its dividend. And fund's 12-month yield tells you little about how a portfolio is positioned today. Take, for instance, a bond-fund manager who has been playing it safe for most of the past year but who more recently has gotten more aggressive by trading U.S. government bonds for racier high-yield bonds. The 12-month yield would mostly reflect management's prior cautiousness, not its bolder stance today.

Yes, the SEC yield has its drawbacks too. The calculation assumes that funds will keep their bond holdings until they mature, which is rare. And it too is a backward-looking measure. So while it might shed some light on what the portfolio has looked like recently, it still may not predict a fund's future yield potential.

Yield isn't the only thing that matters.
As I mentioned earlier, yield is only one component of total return. Pursuing the former too aggressively could come at the expense of the latter. There's really no such thing as a free lunch, and usually the higher the yield, the greater the risk. As an extreme case, consider  Oppenheimer Rochester National Municipals (ORNCX), whose emphasis on lower-rated bonds gave it among the fattest yields in its category going into 2008. But its risky portfolio (which included a helping of leverage) proved disastrous when the financials crisis hit the credit markets, leading to a nearly 50% loss for the year. That's why it can be a big mistake to simply screen for funds with the heftiest yields. What you're really doing is screening for funds that take on the biggest risks. Those funds' hefty income streams may make you feel good for awhile, but they may leave you poorer in the end.

By contrast, the best bond funds often don't have the highest yields.  PIMCO Total Return's (PTTAX) 5% SEC yield is above the typical intermediate-bond fund's, but it's nowhere near the highest in the category. In tough environments, as in 2008, most of the fund's return has come from income. But manager Bill Gross hasn't relied on yield alone for his success. In 2007, PIMCO Total Return was up nearly 9%. Just over half of that return came from income, the rest from appreciation in the fund's bond holdings. That explains why investors shouldn't try to rely on income alone to meet their financial needs. You might be reluctant to tap into your principal, but that's not a big concern if you're taking a bite out of a growing pie.

Instead of chasing after yield, look for funds that have delivered strong returns versus their category peers over long periods of time. And pay special attention to costs. Morningstar research indicates that bonds funds with higher costs tend to be more volatile because managers try to overcome their expense hurdle by investing in higher yielding (and riskier) bonds. In general, avoid bond funds with expense ratios above 0.75%, though cheaper is better.