The Error-Proof Portfolio: True 'Lies' That Yield Can Tell

Stocks, bonds, and funds with healthy yields often beckon as an oasis of stability. This is especially true in uncertain economic environments. Investors don't have to take it on faith that an investment will eventually pay off for them; they can get paid as they go.

And in contrast to so many other financial statistics, it doesn't seem like yield would be subject to as great a fudge factor. What you see is what you get, right?

Well, maybe.

If you buy and hold an individual bond to maturity, you do get what you see, assuming the company makes good on its debt payments. But if you're looking at yields for other securities, such as individual stocks and funds, that yield might not be all it's cracked up to be.

We've often written about the fact that a high yield could indicate a security carries outsized risks. It stands to reason, for example, that the junk-bond fund with a 7% yield is going to be riskier than the short-term Treasury fund with a 1% payout; your payout might be better in the former, but there's also a greater possibility that your principal value could shrink. In a similar vein, holders of financials stocks saw dividend yields climb into the double digits during the financial crisis amid steep share-price declines, but those lush payouts were short-lived as many banks went on to eliminate their dividends altogether.

Those are the obvious ways in which yields might not tell the full story about a security's future prospects. But yields can be illusory--or at the very least subject to misinterpretation--in other ways, as well, making it crucial to dig below the surface if an investment offers a substantially higher payout than competing alternatives.

The Incredible Shrinking Yield
For mutual funds, the yield you receive will depend on prices on the securities already in the portfolio as well as the securities available for the manager to buy at any given point in time. As interest rates have declined during the past few decades, bond-fund managers have seen some of their holdings appreciate, but they've been forced to shop the shriveled-yield aisles for new merchandise, taking their portfolios' payouts down at the same time. That helps explain why the yield you see today might not be the one you pocket next month or next year.

That fact is often reflected starkly in the two different yield statistics available for mutual funds: trailing-12-month yield and SEC yield. As this article discusses, the former is its average payout percentage during the past 12 months. SEC yield, by contrast, provides a more current snapshot, depicting the fund's income payout during the past 30 days (minus expenses) and annualizing that figure over a one-year period. (Trailing-12-month yield is available on Morningstar.com; you can find SEC yield on fund companies' websites and by customizing your data points using the My View feature on  Morningstar.com's Portfolio Manager.)

The bottom line is if you're using trailing-12-month yield as a proxy for what to expect in the future, you may be in for a surprise.  T. Rowe Price High-Yield (PRHYX), for example, has a trailing-12-month yield of 7.5%, but its SEC yield is a less compelling 5.9%. That's not to knock the T. Rowe fund in particular--in fact, it's one of our analysts' favorites--but it does reflect the fact that high-yield bond prices have appreciated sharply during the past few years, taking down bond yields. Of course, that trend might eventually go the other way, and at some point bond funds' SEC yields might be higher than their yields during the past 12 months. But no matter what the environment, it's a mistake to look at SEC yield in isolation.

You've Got Chocolate in My Peanut Butter
Equity-income funds typically focus on dividend-paying stocks. But many of the highest-yielding funds under the equity-income umbrella combine a dose of bonds, preferred stock, or convertibles alongside their equities. So if you're comparing two equity-income funds based on their yields, you might in fact be comparing apples with oranges; the equity-income fund with the bonds, converts, and preferreds might look far more compelling from a yield standpoint, even though a big part of its advantage comes from holding bonds and other securities that typically boast higher yields than stocks.

Perhaps more important, investors holding such funds in taxable accounts might in for a surprise come tax time because they'll pay ordinary income tax on the yield that comes from bonds, converts, and preferreds. Owners of pure dividend-paying funds, by contrast, would owe tax at a rate of 0% or 15% on the income from their funds, making such vehicles preferable for taxable accounts.

That's not to say you should automatically dismiss equity-income funds that aren't pure stock. In fact, a few such funds, such as  American Century Equity-Income (TWEIX), are standouts within their categories, both from the standpoint of yield and total return. Furthermore, it's not like bonds or stocks are kicking off oodles of income at this point, so the tax effects aren't apt to be enormous unless you have a lot of money staked in one of these investments. But it is a reminder to look under the hood when comparing equity-income funds.

TIPS and Tricks
Treasury Inflation-Protected Securities funds provide another potential source of investor confusion on the yield front, as Jason Zweig astutely observed in his Intelligent Investor column in the Wall Street Journal about a month ago. That's because, as noted above, SEC yield takes a fund's yield in the most recent month and annualizes it over a 12-month period. Because TIPS' returns are composed of both the income from the bonds as well as the adjustment their principal values receive when the Consumer Price Index goes up, the funds' SEC yields can get distorted in months when the CPI sees a significant bump up.

To make matters worse, some firms factor in the inflation adjustment into their TIPS funds' SEC yields while others do not. For example,  iShares Barclays TIPS Bond (TIP) recently sported an eye-popping SEC yield of 10.6%, because its yield encompasses the most recent month's CPI adjustment as well as the fund's interest income annualized over a one-year period. By contrast,  Vanguard Inflation-Protected Securities (VIPSX) doesn't bake the inflation adjustment into its SEC yield calculation, so its most recent SEC yield, 0.09%, looks downright miserly by comparison.

For those shopping on yield alone, it might be tempting to conclude that the high-yielding funds are the TIPS category's cool kids, while Vanguard is an also-ran. But just as the iShares TIPS fund is one of  the top TIPS choices for our exchange-traded funds team, Vanguard Inflation-Protected Securities is also one of  our fund analyst team's favorites among traditional TIPS offerings. (Vanguard's conservative take on reporting its SEC yield also attests to its stewardship.) The fact that different firms can produce such different SEC yield figures, however, attests to the importance of digging below the surface when comparing TIPS' yields.

Go Buy Yourself a Little Something � With Your Own Money
Last but not least, closed-end fund payouts--which we call distribution rates--can be illusory, in the worst kind of way. That's because some funds, in the interest in delivering a steady stream of income to shareholders, might choose to augment the actual income from the securities in the portfolio with little bites of their shareholders' own capital.

If funds do so sparingly, it's not a huge crisis: After all, if a fund keeps its payout steady, it's unlikely to trade at a discount to net asset value, which helps shareholders. But some funds are habitual offenders on this front, cheerfully returning shareholders' capital on the way to delivering distribution rates that often top 15%. Our closed-end fund analyst team has been shining a light on this practice for the past several years; this slide show details the practice, as does this article.

It's worth noting that funds aren't typically sneaky about returning shareholders' capital; my colleague Mike Taggart opines that even though this practice is invariably well-disclosed, shareholders rush past it because the funds' payouts can be so tantalizing. But my advice on this front is straightforward: If a fund's payout is appreciably higher than other funds buying into a similar asset class, the onus is on you to ask questions first, write a check later (or maybe never).

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