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Yield Is Underrated

But not in the way you think.

Last week, I found myself engaged in a somewhat complicated exercise to determine the risk levels of various bank-loan funds. (Bank-loan funds, sometimes called senior-loan or floating-rate funds, are a lower-quality bond-fund type; they're perhaps not quite as risky as junk-bond funds but definitely riskier than high-quality bond funds.) I wanted to replace one of the bank-loan exchange-traded funds in my model portfolios with another fund, preferably a lower-risk option given the current spot in the economic and credit cycle.

In an effort to identify the lower-risk offerings within this high-risk category, I went straight to portfolio statistics. I compared the various funds' credit-quality ratings relative to one another and the Morningstar Category, and I checked cash holdings to gauge the funds' liquidity. I also pored over the analyst reports to assess the presence of other risk factors that perhaps I was missing by looking at the portfolio itself. I was toggling from fund to fund, documenting the risk profiles of each of the contenders.

But as I immersed myself in data, something dawned on me. Was I completely overlooking a measure that might be a useful shortcut for evaluating the risk levels of these funds? Trained for so many years to pay minimal attention to yield and instead focus on total return, I had completely ignored yield as part of my efforts to measure the riskiness of these investments.

While investors may do themselves a disservice by gravitating to the highest-yielding products, yield can be a useful marker of risk, especially for bonds and bond funds. That's not to say that lower-yielding funds are automatically safer (that's not necessarily the case) or that higher-yielding ones should be marked with a skull and crossbones. But if you're looking for a shortcut to understand the risk profile of your fixed-income holdings, yield isn't a bad starting place.

Deals Like This Won't Last The reason why yield can be such a useful indicator of risk in bonds and bond funds relates to arbitrage, the tendency for market participants to swoop in when unwarranted price discrepancies emerge. Everyone's on the hunt for return, so if there's a bond out there that has a higher yield than other investments with similar risk attributes, investors will tend to bid it up in a hurry, pushing down its yield. Yield inefficiencies, meaning you can earn an above-average yield without taking any additional risk, rarely persist for long among bonds, especially high-quality ones that are widely traded. For one thing, yield is the bulk or all of the return you earn as a bond investor; what you see is usually what you get, especially for high-quality bonds. Moreover, there are a lot of bonds with similar characteristics in terms of maturity, credit quality, and so forth, and many professional investors using computer programs to sort among them. If a bond has a compelling yield relative to other bonds with similar attributes, it won't tend to be able to maintain it for long.

That's why yield can be so useful as a risk marker, especially for bundles of bonds held in mutual funds. It may be possible for one or two bonds with higher yields to go unrecognized, even if they have no more risk than lower-yielding bonds with similar attributes. There can be structural reasons that contribute to pricing inefficiencies in a given market, too; for example, other market participants may not be able to invest in a given bond type, thinning the pool of investors who can invest in them and contributing to the possibility of pricing inefficiencies. The municipal-bond market is a good example. Because institutional investors like pensions don't benefit from the tax break that munis earn, the pool of muni buyers is constrained to start with. And there simply might not be that many market participants who are looking for North Carolina midquality bonds. Pricing inefficiencies can more readily emerge in less efficient markets than in hyper-efficient ones like Treasuries and high-quality corporates.

But think of it this way. If a bond fund amasses a whole portfolio of bonds that are yielding more than rival funds investing in the same pool, that can be a signal that its manager is systematically accepting higher risk in exchange for delivering a higher yield. That may give it a return edge--even a persistent one--but it's also likely to translate into higher volatility and the potential for real losses if you need to sell a bond or a bond fund amid a period of weak performance. A propensity to invest in lower-quality but higher-yielding credits may contribute to performance that moves as much in line with stocks than bonds; lower-quality, high-yielding bonds aren't likely to be as effective on the diversification front as high-quality bonds.

Of course, it's also important to point out that funds can deliver higher yields than their peers in another way, and that's by keeping their expenses down. A fund's expense ratio is deducted from its yield, so a fund charging 0.50% per year will have a better yield than one with an identically invested portfolio and a 0.75% expense ratio. That's why a key check before assuming that a fund is taking on big risks relative to its peers is to assess its expense ratio. If a bond fund's Morningstar Fee Level is Average, Above Average, or High, and its yield is also higher than its peers, that should be your cue to sniff around for what risks it's taking to deliver it. That's one reason that Morningstar analysts tend to not recommend high-cost bond funds; their managers may take additional risks to help overcome the yield reduction that accompanies a high expense ratio.

Most Useful for Less Obvious Risks Those risks can come in a few different forms. The obvious two risk levers that funds can pull to deliver a higher yield than peers are interest-rate risk and credit risk. Miriam Sjoblom discusses duration, a measure of interest-rate sensitivity, in this article. Credit risk is more common among core bond funds; to help you identify how much credit risk lurks in a portfolio, Morningstar provides each fund portfolio's allocation to each of the rungs on the credit-quality ladder, as well as the average allocation to that credit-quality band for other funds in the same category.

Those risks are fairly simple to sleuth out at the portfolio level, but there are other instances when yield can be particularly useful as a risk flag. One is if the bonds in a portfolio aren't rated, or if the data on portfolio holdings aren't widely available. Yield can also be a useful risk marker if a fund traffics in illiquid bonds; if other bond-market participants believe they may not be able to unload the bond in bad market conditions, the bond's yield will be higher than the yields on other bonds.

You may decide that you're OK with the volatility that can accompany higher-yielding bonds and bond funds. But if you own bonds to serve as the shock absorbers for the truly risky investments in your portfolio, the highest yields won't be your best options.

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