Ignore Total Return In Evaluating Bond Funds

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 |  Includes: MBB
by: Kurt Shrout

In the Comments in response to my recent article entitled, "The True Yield of Your Bond Investments", I noticed some confusion regarding the difference between yield to maturity (YTM) and the total return (TR) of a bond fund.

Yield to Maturity

YTM is the best measure of a bond fund's yield when none of the bonds involved can be prepaid or the like. (When some of the bonds involved can be prepaid, yield to worst [YTW] or option-adjusted yield [OAY] is the best measure.) YTM is a measure of the future return of a bond fund if there is no change in the current market interest rate(s) for the bonds involved going forward. YTM assumes market interest rate(s) for the bonds involved will remain the same and, therefore, will not impact the net asset value (NAV) of the fund.

Total Return

TR includes capital gains and/or losses and interest/dividend payments. TR should also include the expenses of the fund (as a capital loss). TR is a measure of the past return of a fund, and it includes changes in the NAV of a fund due to changes in market interest rates for the bonds involved. TR includes capital gains and/or losses due to the impact of market interest rate changes.

Yield to Maturity vs. Total Return

YTM and TR are not comparable. TR includes more than yield, and it is a measure of past performance. YTM includes only yield, and it is a measure of future performance. Also, TR is not an appropriate statistic to use in deciding whether or not to buy a bond fund. YTM is an appropriate statistic to use in deciding whether or not to buy a bond fund.

Whether interest rates rose or fell a certain amount in the past should be irrelevant in selecting a bond investment. Interest rates will almost certainly rise or fall a different amount in the future. Moreover, if interest rates rose in the past, they may fall in the future; and if interest rates fell in the past, they may rise in the future.

If you calculate a projected future TR for a particular bond fund, and you are good at projecting interest rates for the type of bonds involved, it may be an appropriate statistic to use in deciding whether or not to buy the bond fund. However, TR itself is not a "projected future" statistic, it is a past performance statistic.

Example: iShares Barclays MBS Bond Fund (NYSEARCA:MBB)

MBB has an average annualized total return of 5.68% since its inception on 3/13/07. Overall, mortgage-backed securities (MBSs) interest rates have decreased, and MBB has experienced a capital gain since its inception, so the 5.68% reflects an overall capital gain and interest payments. The 5.68% seems to also reflect the fund's expenses ― currently 0.26% per year.

What happened in the past is not the same as what will happen in the future. The current interest rates for MBSs may go up, down, or stay about the same. In reaction, MBB's NAV may go down, up, or stay about the same. In the future, there may be no overall capital gain that inflates MBB's total returns. Instead, there may be an overall capital loss that deflates MBB's total returns.

Pretend that the current interest rates for MBSs stay exactly the same going forward. YTM tells you what yield you will experience in MBB, including interest and an overall capital gain or loss, in this scenario. There will be an overall capital gain if MBB is more largely holding MBSs currently valued below par value. There will be an overall capital loss if MBB is more largely holding MBSs currently valued above par value.

The evidence indicates that MBB's YTM is something very close to 2.14%, and its fund-expenses-adjusted YTM is something very close to 1.88%. These figures include a future overall capital gain or loss due to MBB more largely holding MBSs valued below or above par value. This future overall capital gain or loss is inevitable. In addition to this inevitable capital gain or loss, MBB will experience either a capital gain or loss depending upon whether MBS interest rates fall or rise.

If we discuss what happens when MBB sells MBSs prior to maturity, the conversation becomes more complicated. In the end, though, it does not matter. YTM remains the true yield of MBB.

Conclusion

Don't buy, sell, or hold a bond fund based on its TR. There is not, necessarily, a relationship between a fund's past performance and a fund's future performance. Look at the fund's YTM, YTW, or OAY ― whichever is the best yield measure for the particular fund ― and, then, make adjustments, such as the fund expenses adjustment I made earlier in this article. (I intend to describe the other adjustments to be made in a future article[s].)

In addition, consider the impact of likely future interest rate changes. For more information about this, please see my article entitled, "Future Inflation's Likely Impact on Bonds".

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I manage a portfolio which includes a mutual fund with holdings similar to those of MBB. This mutual fund is being exited.