Q: I see a lot of different yields quoted for bond funds. What's the best one to use?
A: Many companies provide a fund's yield over the past 30 days or 12 months, and they may calculate it in different ways. Those measures indicate what a fund earned in the past. But most experts settle on a fund's 30-day SEC yield as the best guide to your future returns.
Conservatively calculated, the 30-day SEC yield uses a standard formula that estimates a fund's total returns by looking at yields to maturity based on recent market prices of bonds, including bonds that can be redeemed before their maturity date. It factors in principal return and it includes reinvested income as maturing bonds in the portfolio are replaced with others.
That combination makes it one of the best indicators of your "expected total return," says Curtis Hollingsworth, a Fidelity Investments portfolio manager who runs the Fidelity Spartan U.S. Bond Index Fund (FBIDX).
Another plus: Everyone uses it. The SEC requires fund companies to report 30-day SEC yield, creating an apples-to-apples comparison across the industry. Sites such as Morningstar.com are now featuring SEC yield more prominently as well.
In today's market SEC yield may also be closer to your expected returns. That's because many bonds are trading at a premium price, above 100 cents on the dollar, which the SEC yield factors in. Other yield measures don't account for the potential loss of capital that can occur when those premium bonds eventually mature and return to their "par" value of 100 cents on the dollar.
Granted, SEC yield has its limits. It assumes that bond prices and interest rates stay stable. If rates rise sharply, you'll likely earn less than the SEC yield, especially if you own a long-duration fund with lots of bonds that are highly sensitive to rising rates. (Interest rates and bond prices move in opposite directions. Duration is a measure of how sensitive a fund's NAV is to changes in interest rates.)
Furthermore, for high-yield or "junk" bond funds, the SEC yield doesn't reflect the amount of credit risk they take, which can have a big impact on your returns. And for funds that invest in mortgage-backed securities, both SEC yield and distribution yield are heavily influenced by the most recent month's mortgage prepayment rates, potentially overestimating the fund's future income. (If homeowners refinance their mortgages or pay off principal early, the value of mortgage-backed securities may decline.)
Focus on total returns
What really matters is your total returns: the combination of income and capital gains you take home as a shareholder. A fund with a high distribution yield may look attractive in today's low-rate world, for example, but the share price could tumble if it holds lots of long-term bonds and interest rates rise.
Indeed, in today's low-rate world, checking a fund's duration is critical, says Andrew Feldman, an independent financial adviser in Chicago who uses a variety of measures — not just yield — to evaluate bond funds.
"High yields are sexy and attractive," he says, "but you want to be sure that when rates go up, the fund won't lose value."
One way to think about duration is to match it to your holding period for the fund, says Hollingsworth. If you plan to hold the fund for longer than its duration, you would actually benefit from rising rates since the fund will eventually invest in bonds paying higher rates. If your horizon is shorter than the fund's duration, you'd be hurt by rising rates, he says.
Overall, checking your fund's SEC yield, duration and credit risk can help you determine if it's right for your portfolio.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com.