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The risks and returns on domestic and overseas bond funds

The risks and returns on domestic and overseas bond funds (Part 1 of 7)

The risks and returns on domestic and overseas bond funds

What are the components of bond fund returns?

This series continues our discussion of international bond funds, An investor’s key guide to international bond funds. In this series, we will analyze the risks and returns in overseas and domestic bond funds. But first, we will discuss the various components used to compute an ETF’s total return.

Returns on bond funds like the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF (LQD) are estimated by measuring their total returns. Domestic bond funds have four components to total returns, namely the yield on the bond ETF, price change in the fund’s Net Asset Value (or NAV), capital distributions out of the profits made out of selling component bond holdings, and reinvestment income earned on distributions made by the fund.

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Yields earned on the bond fund: SEC yield and distribution yield

While there are various yield measures used to compute the yields on bond funds, the most common measures are the SEC yield and the distribution yield.

The SEC yield has been developed by the Securities & Exchange Commission (or SEC) and is a reporting requirement for ETFs. The SEC yield measures the return the ETF would earn assuming each and every security in the fund was held to maturity. It’s computed after considering reinvestment income on distributions and after deducting the applicable ETF expenses and commissions. The forward-looking and standardized nature of the SEC yield makes it the one of the best yardsticks for ETF performance comparisons. For example, the 30-day SEC yield on the iShares 20+ Year Treasury Bond ETF (TLT) was reported at 3.22% as on May 6, 2014, while the 30-day SEC yield for the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) was reported at 3.14% on the same date.

However, as funds rarely hold bonds to maturity, the SEC yield is used in conjunction with the distribution yield, to compare performance. The distribution yield on an ETF is akin to the current yield and is calculated by dividing the actual dividend income distributed by the ETF over the past 30 days (after subtracting expenses) by the NAV of the fund and annualizing the result. Unlike the SEC yield, the distribution yield calculation does not consider reinvestment income from the fund. For example, the distribution yield on the PowerShares Emerging Markets Sovereign Debt Fund (PCY) was reported at 4.59% (as on May 7, 2014).

As it uses current NAV as the denominator, the distribution yield is not necessarily indicative of future yield as the bonds in the portfolio may be trading at a premium or discount, and which are likely to approach par value as maturity approaches. Hence, the distribution yield tends to be lower than the SEC yield when interest rates are rising, and higher than the SEC yield when interest rates are falling.

Price fluctuations in the fund’s Net Asset Value (or NAV)

The Net Asset Value (or NAV) of the ETF will fluctuate as the value of the underlying portfolio changes. One of the major factors that influence NAVs are changes in interest rates, which cause changes in bond prices, since bond prices and interest rates move in opposite directions. Until the bonds are sold, changes in their values will be reflected in the fund’s NAV. For example, the NAV per share for the iShares Core Total U.S. Bond Market ETF (AGG) was reported at $108.70 as of May 7, 2014.

Since interest rates lately have been at near-historic lows, coupon interest income from bonds is also low. Hence, changes in the fund’s NAV may form a considerable part of an ETF’s returns.

Distributions in terms of capital gains

When bonds in the ETF portfolio are sold, there may be a gain or loss realized on the sale price. The gain on the sale if any, is distributed amongst fund holders and the NAV of the fund falls after the distribution is made. Fund holders may elect to either receive the gain or have it reinvested in the ETF. Capital losses are carried forward to be applied against future capital gains.

Interest earned on distributions made by the fund

ETF investors have the option of having income and capital gains distributions reinvested in fund. This has the effect of compounding returns for investors as the distributions earn interest as well. This also forms part of the total return on ETF investments.

The next part will discuss return comparisons between bond funds that invest in the U.S. Treasuries and international government securities.

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