A reader writes in, asking:
“My question is about bond fund returns. Which number is the best to use for determining what a customer actually gets in his account: yield or average annual returns? On the Vanguard web site the short term bond index fund has a yield of 0.42% and a 10-year average annual return of 3.77%. Which number should I be looking at?”
If you want to know how a bond fund did over a given period, look at annual return figures. If you want an estimate as to how a fund will do going forward, use the fund’s yield.
Components of Bond Returns
A bond fund’s return can come from two places:
- Interest on the bonds it holds, and
- Price appreciation for the bonds it holds if interest rates fall (note that this works in the other direction when rates rise instead of fall).
Right now, most bond funds have very good recent past performance figures. That’s because interest rates have been falling for the last few years, pushing bond prices up. But with rates as low as they are right now, they can’t fall very much further.*
In other words, when a bond fund’s yield is very low, that tells us that, for the near-term future, both of the return components are likely to be very low as well — the fund is likely to be earning a low rate of interest, and the fund can’t earn much via price appreciation, because there’s so little yield to give up.
For example, looking at the Vanguard Short-Term Bond Index Fund mentioned above, we see that its SEC yield is currently 0.42%, and it has an average duration of 2.7 years. This tells us that, for the near-term future at least, there’s nowhere for 3.77%-type returns to come from.
- Unless nominal interest rates fall below zero, the most price appreciation the fund could experience is 1.13% (that is, a 0.42% decline in rates, multiplied by 2.7-year average duration), and
- The only way for the fund to earn interest in excess of its 0.42% yield would be for rates to rise — which would hamper the near-term returns for the fund because it would push the price of the fund down.
Higher Yield Means Higher Risk
It’s important to understand, however, that while bond funds with higher yields do have higher expected returns, they also have the higher risk (either interest rate risk, credit risk, or both). It’s a very direct relationship. In other words, when choosing a bond fund for your portfolio, it is not usually a good idea to just pick the one with the highest yield.
*Please understand that this is not a prediction that rates will be rising any time soon. They might, or they might not. I have no idea.