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A previous post on bond ETFs elicited requests to explain why it is important to look at the yield-to-maturity instead of the yield quoted on financial portals like Yahoo Finance. Just why, for example, is it misleading to use Yahoo Finance’s quote of 4% on the iShares Canadian Short-Term Bond ETF [TSX:(XSB)] when’s website quotes the yield to maturity at 2.1%.

Oliver McMahon, Director of Product Management for iShares Canada, said the 2.1% yield to maturity is what an

investor holding the underlying bonds within the fund would earn per year if they could hold them until they mature.

Some of the 2.1% annual return is due to the coupon payments, but some is due to the price of the bonds moving towards par.

In other words, the prices of the bonds in the ETF’s portfolio have been bid up past their par values; as time passes and maturity dates are approached, prices edge back down to par. This decline in prices offsets the coupon yield and pushes it toward 2.1%.

The unit price of the ETF will edge down over time due to this factor but it will be hidden in the fluctuations in market rates;

…while we can be reasonably comfortable assuming the underlying portfolio will produce a yield equivalent to 2.1% per annum over the life of the portfolio, it should not be assumed that this will be a constant return over each year. It may be that the return is higher one year and lower the next.

The stream of interest payments will also edge down said Aubrey Basdeo, Head of Fixed Income, Barclays Global Investors. One can see the decline already in the past three or four quarters of distribution payments. I didn’t quite catch the reason for this and Mr. Basdeo has so far not responded to a request for clarification. My guess is that it may come about from the portfolio rolling over into new bonds at lower interest rates.

Yet another complication noted Mr. McMahon:

The portfolio of XSB does not hold bonds until maturity. The product has been created to be representative of the short end of the bond market, which is generally understood to be 1 to 5 years. Thus, as a bond’s life is reduced to less than 1 year it is removed from the index (thus sold from the portfolio) and the proceeds are reinvested across other index holdings. This means that the yield to maturity, while being a useful measure of the return in the market, is not a rate of return the fund can be assured of achieving.

And here, we thought ETFs would simply the construction of portfolios!

Source: Using the Right Yield Data for Bond ETFs