(PUB) Investing 2015

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As yields across most of the market remain low,
income-seeking investors may be increasingly
tempted to stretch for yield. We looked for signs
of trouble in recent yields of the 85 funds in the
Morningstar 500 that make monthly income distri-
butions. Fund yields tend to reflect the broader
market—for instance, significant quantitative eas-
ing in the United States, eurozone, and Japan in
recent years has pumped up bond prices, thereby
depressing these funds’ yields. Beyond that,
each fund’s strategy and risk profile will shape its
yield, making it tougher to draw conclusions
across groups of disparate funds.
We often keep an eye out for funds with eye-popping
yields, as they can signal that a fund has taken on
big doses of credit or liquidity risk. For this group,
however, we took a different tack. We first looked for
funds whose 12-month yield as of February 2015
was significantly lower than their median 12-month
yield over the trailing five-year period, as evidence
they may be holding big chunks of high-priced or low-
coupon bonds, which may leave them more suscep-
tible if yields rise suddenly.
The funds sporting the lowest yields relative to the
longer trailing period have generally pulled in
the reins as of late. As nonagency mortgage-backed
securities have rallied in recent years, the team
backing TCW Total Return Bond TGLMX and
Metropolitan West Total Return Bond MWTRX
has taken gains and built up larger-than-usual stakes
in U.S. government fare as ballast and dry powder
for future opportunities. Unlike some peers, neither
Vanguard Short-Term Tax Exempt VWSTX or the
periodically aggressive Wells Fargo Advantage
Short-Term Municipal Bond STSMX has loaded
up on longer-maturity or lower-quality bonds to
eke out extra yield. The relative decline of Fidelity
Capital & Income’s FAGIX yield reflects man-
agement’s willingness to take recent gains from its
high-yield stake (though the fund held 19.9% of
assets in equities as of January).
We also looked for funds exhibiting negative net
asset value growth over that trailing five-year period,
as eroding NAVs can jeopardize a fund’s ability to
sustain its income distributions.
The negative NAV growth of PIMCO Emerging
Local Bond PELBX and T. Rowe Price Inter-
national Bond RPIBX bears watching but is under-
standable given the recent strong U.S. dollar rally
and turmoil in Russia and Brazil. The higher volatility
of unhedged world- or emerging-markets-bond
funds also increases the risk that squeamish investors
might sell the funds at the wrong time, thus locking
in losses. Should those funds find themselves digging
their way out of a deep hole, they may be less
able to support their income distributions over the
longer term.
Total return is the best way to tally gains from
income and NAV growth, but the tepid NAV
growth of the other funds above (shown in nominal
terms) raises a broader concern for income-oriented
investors. In real (or after-inflation) terms, those
nominal NAV returns start to dip further into negative
territory—inflation returning to or exceeding the
long-term 2.5% –3.0% historical average could impair
the purchasing power of their future income
streams. The solution to that quandary is beyond
the scope of this article, but the quandary
itself is worth highlighting.
By design, the Morningstar 500 excludes funds
that consistently stretch for yield or erode their NAV
over time. Yet given abnormally high valuations
across broad swaths of the fixed-income markets, we
wanted to take the funds’ temperature. Investors
would do well to apply these tests to other income-
oriented funds they are considering in order to
flag those that risk the permanent loss of capital in
the pursuit of above-average yields. œ
Contact Michael Herbst at
When a Fund’s Yield Flashes Red
Income Strategist | Michael Herbst