The payout rate is not equal to the return
It’s easy to be wowed by what seems like a proverbial “free lunch” in the investment world. Nowhere is this more prevalent than in the world of fixed income securities (i.e. bonds and similar investments). There are many potential topics to discuss in this context. But perhaps the most common misconception I notice among investors emerges when it comes to equating monthly distributions with actual return.
YTM is what matters
Take the case of short-term bond funds and the iShares CDN Short-Term Bond Index ETF. Its current interest distributions are roughly equal to an annualized rate of 3.3 percent. Although I have no real proof, I firmly believe that many investors equate this 3.3% payout rate with the “yield” of XSB. The websites of iShares and other ETFs provide a lot of interesting information.
In the context of this topic, the yield to maturity (YTM) is the most significant data on the XSB profile page. The YTM was recently listed at 1.89% per annum. The fund’s 3.3 percent payout rate is real, but that’s not all.
Periodic coupon interest payments on a bond are part of its total return. The other part is the difference between the purchase price and the maturity or face value. And with interest rates (and bond yields) at historic lows, the price of most bonds will drop between now and maturity.
XSB’s 3.3% interest payout excludes guaranteed capital loss by maturity on virtually all bonds. The YTM counts both the coupon interest and the price change until maturity. And this is the number you should be concerned about since today’s YTM is a very good indication of how the bond will perform in the future if it is held to maturity.
Note that the quoted YTM is calculated before the management expense ratio (MER) deduction of 0.26 percent of XSB. Thus, the net YTM can be estimated by subtracting the MER from the quoted YTM. In the case of XSB, the net return is around 1.63 percent per annum – less than half of the net interest distribution payments. A more prominent example is the Claymore 1-5 Year Laddered Corporate Bond ETF. CBO’s 2 percent net YTM is less than half of its 4.6 percent payout rate.
The worst performance is better
At least with ETFs the fees are relatively low and YTM data is readily available online. This information is not as accessible with short term bond mutual funds. Although a few companies like RBC / PH&N regularly update the YTM figures, most do not disclose this data publicly. But mutual fund companies should be able to provide this information over the phone. For funds and ETFs investing in corporate bonds, high yield bonds and preferred stocks, it is ideal to get a number similar to YTM called worst-case return (YTW) instead of the current yield on bonds or preferred shares.
The next time you feel pressured into a fund because of its unusually high payout rate, understand that you are overestimating either the fund’s true “performance” or its true exposure to risk. Hopefully, this awareness will trigger enough questions for you to be better informed before you invest.
Dan Hallett, CFA, CFP, is director of asset management for HighView Financial Group and a contributor to thewealthsteward.com. He has spent over a dozen years researching investment funds, portfolio managers and financial markets. Former President of Dan Hallett and Associates Inc. in Windsor, he is now responsible for manager research, portfolio construction and investment program design at HighView. Mr. Hallett holds a Bachelor of Commerce degree from the Odette School of Business at the University of Windsor.