BOSTON — Bond mutual funds paying the highest yields today probably won't be the ones producing the most income dollars for investors in future years.
In a new report, the research group Morningstar Inc. looked at bond funds that paid the highest yields five years ago and examined their cumulative dollar income payments over the next five years. The study found that just 16 of 1990's 50 highest-yielding funds were among the top 50 income generators five years later, said Jeff Kelly, a Morningstar analyst.
The returns of many of these funds were hurt on a relative basis because they bought high-priced bonds (i.e., bonds trading above their maturity value), Kelly said. As these bonds approach maturity their prices naturally fall toward par value of 100 cents on the dollar, Kelly said.
Funds that pay more than 100 cents on the dollar for bonds usually do so specifically because those bonds boast above-average yields. But if the fund pays out such bonds' full interest to shareholders, the fund also must reduce its principal value over time, as the bonds mature at prices below what the fund paid.
So even though shareholders gain higher yield upfront, they risk seeing their share value eroded over time. "As the fund's net asset value [per share] shrinks, or at least fails to grow, there's less of a base from which to draw income, no matter how high the yield percentage," Morningstar notes in its report.
Among the funds that suffered the worst erosion in value during the five-year period ended Dec. 31, 1994, because of investments in high-priced bonds, were Franklin U.S. Government Securities Series Fund and Van Kampen American Capital Government Securities Fund, Kelly said.
By contrast, a fund that offered a high yield and also saw its net asset value appreciate in the five-year period was Los Angeles-based FPA New Income Fund, Kelly said.
Managers of the FPA (First Pacific Advisors) fund didn't distribute the fund's full yield, Kelly said. Instead, the managers amortized, effectively retaining, a portion of the bonds' interest payments before distributing the income, Kelly said.
"More funds don't operate the way FPA does because the funds are sold to investors on the basis of their yields, and amortizing, while responsible, does lower the distributed yield," Kelly said.
Regulations from the Securities and Exchange Commission don't require taxable bond funds to amortize the paying out of premium coupons, he said.
What should bond fund investors look for if they're chasing high yields?
First, consider buying funds that invest in longer-term bonds, Kelly said. Although more volatile, longer-term bonds naturally pay out more income over time, and the principal-value penalty for high-priced issues is more spread out.
Second, pick bond funds that keep shareholder costs as low as possible, Kelly said. "It rarely makes sense to pay more than 1% annually in expenses for a fixed-income fund," he said.
Finally, investors would be better off owning funds that use "intelligent accounting practices"--or amortize--to help preserve share value, Kelly said.
He also noted that investors should be careful to understand the specific types of bonds that a fund buys. The highest-yielding funds generally own the lowest-quality bonds, such as corporate "junk" issues or debt of emerging economies. Those types of bonds can be lucrative investments over time, but they entail much greater risk of defaults and other problems.
"In sum, it always make sense to look beyond bond funds' current yields--even when income is the main goal," Kelly said.