Gil’s Musings

What is “Yield”?

With interest rates bouncing off of generational lows, investors are scrambling to find yield. However, many will find their fingers in the occasional mousetrap as they feel around in the dark, I fear. So some basic discussion of what comprises yield is in order, just to save a few fingers. The term yield means many things to many people. A typical response to the “what is yield” question might be, “what I get back from my investment”. But that response seems to encompass price in addition to yield. What if an investment starts at $100, pays $5 over a year, and matures and pays $101? Is that a 5% or 6% yield? My answer would be that’s a 5% yield with a 6% total return, since cash flow and principal value get blended together. So to me, yield is just the cash flow component. This is where it gets tricky. So what if an investment starts at $100, pays $5, and comes due a year later at and pays off $95. Then you receive a 1099 that shows $5 return of principal. In that case your rate of return is 0%, your yield is 0%, and you got $5 of your own money back.

One problem is that things are not always as they appear to be. I recently had a conversation with an investor who challenged the notion that interest rates were low, simply because his bond fund paid him much higher “yields” than were available elsewhere. He attributed that to his smart manager. I attributed it to voodoo accounting. Investors often have a hard time contextualizing that a mutual fund manager can arbitrarily contrive a “yield” to pay from a fund, when the fund’s actual returns have nothing to do with the payment. But the fund could rank #1 in Money magazine for “yield payout”, couldn’t it? I liken this to an airplane pilot who likes to overload his planes and cut his cost per seat. However, a plane is liable to drop from the sky, while a fund could go on a steady descent that it cannot overcome. So a fund with a $10 share price could very well pay 10c per share per month, or $1.20 per year. Surely, that’s a 12% yield, right? It shows in the Wall Street Journal that way. Well, what if the fund actually earns 2 cents per share per month, but the fund management simply decides to pay five times that amount? In this example, the fund earns 2.4% (2c x12mos=24c/$10 price=2.4%). The other 96 cents per year is considered “return of principal”. Can they do that? You bet. Why would they? They are trying to keep existing shareholders happy and attract new ones. You don’t do that by cutting the distribution, and people just don’t know any better. So they often simply look down the yield column in the paper and just buy the highest one. Now, in their defense, these funds actively disclose their voodoo math. See the attached shareholder notice from MFS on their closed-end fund MFS Intermediate (NYSE: MIN). Their disclosure shows a distribution rate of 8.51%. But they also show that 54% of that was not actually “earned” by the fund. See the “Return of Capital” line on the sheet.

This MFS fund does not borrow money to enhance its yield, but others do. Leveraged closed-end funds are popular because they can generate substantial cash flows from borrowing short and lending long. However, you may remember this terminology as one of the culprits in the Savings and Loan debacle of 1990. Leverage is not a bad thing per se, especially when interest rates are declining, and these funds can make money from the “carry”. But woe to the investor who holds a levered fund in rising rates, when that comes home to roost. I am not castigating levered funds, or even unsustainable voodoo payouts as we hold several of these funds on our books. I am simply encouraging investors to understand what they own, why they own it, and to challenge their assumptions about what comprises yield.

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