Last week, I warned not to confuse bond fund/ETF distributions with yield-to-maturity (YTM) or total return potential. I was a bit surprised by the sensitive chord this struck with so many investors. In the spirit of brevity and focus, I glossed over some finer points pertaining to bonds and yields. So, this week, I delve more deeply into a few issues that emerged from the many public and private messages I have received over the past week.
Clarifying YTM
The main thrust of last week's post was to prompt investors to focus more on YTM than on current yield or distribution rates. But even YTM is a theoretical figure.
Technically, a bond's YTM is the rate of return that equates the purchase price of a bond with the present value of all future coupon payments and the repayment of the maturity (or par) value. I gave the impression that a bond's YTM is a definitive measure of a bond's future return when held to maturity. While it's the best forward-looking estimate available, it's not precise.
The YTM formula assumes that all interest payments are fully reinvested (without cost) into the same bond at the YTM. This just isn't possible because yields and YTM levels aren't constant; and full reinvestment at no cost isn't possible.
Relevance of YTM
Many sharp readers pointed out that most bond funds and ETFs don't just hold bonds to maturity, which would make the YTM figure less relevant. This is a good point. In fact, I was surprised by the amount of turnover in what is supposed to be a 'passive' bond fund. Yet the iShares CDN Short-Term Bond Index ETF has turned over its portfolio more than 60 per cent annually over the past five years. (See page 9 of XSB's 2010 Management Report on Fund Performance for year-by-year turnover data.)
Despite the above points on the imprecision of YTM and the fact that bond yields can and do change, an investor's ultimate return can't be known with certainty in advance at any point in time. But the YTM remains an excellent indicator of future total return over the term of the bond (or average term of a bond fund). To that point, I would urge investors in bonds and bond funds/ETFs to focus on YTM when looking at return potential at the time of purchase.
Impact of rising rates
Many are leery of bonds today because of the prospect of rising interest rates (and the downward price pressure that would result). And some argue that YTM isn't such a good indicator of future fund or ETF return in a rising rate environment. In this context, there are two important noteworthy points.
First, in all of my 17 years in this industry, there has been a near-constant sentiment that historically low interest rates are poised to rise. It's true that the farther rates fall, the less room they have to fall. However, as I wrote last year bonds remain one of the key portfolio building blocks. While some might de-emphasize bonds a bit based on an expectation of rising rates, you don't want to be out of them altogether.
Second, while many have been calling for the end of the bond bull market and the damage that awaits bond-heavy investors, I have rarely seen any quantification of the potential losses that bond investors could suffer. So, I ran some simple calculations.
Bond bear market scenarios
