SEC Yield

From Bogleheads
Jump to navigation Jump to search

The SEC Yield of a fund is a standardized calculation of the fund's yield; this allows investors to compare funds from different issuers. For a bond fund, the yield is based on the yield to maturity, less expenses. For a stock fund, the yield is based on the dividend yield, less expenses.

Definition

Vanguard has a good informal definition [1]:

A non-money market fund's SEC yield is based on a formula mandated by the Securities and Exchange Commission (SEC) that calculates a fund's hypothetical annualized income, as a percentage of its assets. A security's income, for the purposes of this calculation, is based on the current market yield to maturity (in the case of bonds) or projected dividend yield (for stocks) of the fund's holdings over a trailing 30 day period. This hypothetical income will differ (at times, significantly) from the fund's actual experience; as a result, income distributions from the fund may be higher or lower than implied by the SEC yield. The SEC yield for a money market fund is calculated by annualizing its daily income distributions for the previous 7 days.

The formal SEC definition[2] gives the official formula

Where:

  • a = dividends and interest collected during the past 30 days
  • b = accrued expenses of the past 30 days
  • c = average daily number of outstanding shares that were entitled to distributions
  • d = the maximum public offering price per share on the last day of the period

It also includes clarifications of the definition. In particular, "Dividends and interest" for a bond is computed from yield to maturity, or yield to call if the bond is likely to be called, not the coupon payments on the bond.[2] The reason for the 2 and 6 in the formula is that the SEC yield is twice the six-month yield. This corresponds to the way bond yields are reported; a $1000 bond with a $10 coupon earns 1.00% every six months, and reports a 2.00% yield even though a 1.00% return every six months is a 2.01% annual growth rate.

Bond funds

For a bond fund, the SEC yield is related to the expected future total return. It will not match the return in practice, as bond prices change when their yields change, and funds do not hold bonds to maturity.

The examples in this section show how the SEC yield works with a bond trading at par and a bond trading at a premium, both with a 2.00% SEC yield.

  • Bond A (par): A bond with 10 years to maturity and a par value of $1000, paying a $10 coupon every six months, with a par value of $1000 which will be paid at maturity. This bond is currently worth $1000.
  • Bond B (premium): A bond with 10 years to maturity and a par value of $1000, paying a $15 coupon every six months, with a par value of $1000 which will be paid at maturity. This bond is currently worth $1090.23, calculated from the yield to maturity by compounding a 1.00% rate every six months as .[note 1]

Similar calculations were used below to show how the value of both bonds relates to changes in their yield. A fund holding either bond would report a 2.00% SEC yield if it has no expenses, or a 1.90% SEC yield if it has 0.10% annual expenses.

If yields stay the same

Suppose that the SEC yields on both bonds remain 2.00% in six months. Bond A will be worth $1000, with a 1% return from the $10 coupon. Bond B will be worth $1086.13 = PV(1%,20-1,15,1000,0). The holder of Bond B received a $15 coupon but the bond price declined by $4.10 = (1090.23 - 1086.13), for a total return of $10.90 = (15 - 4.10), which is also 1% of the bond price (1090.23). If the yield on a bond (or on the bonds in a fund) does not change, its return over the six months is exactly half the SEC yield.

This equality also holds over longer periods of time, provided that all coupons are reinvested at 2% annually. Thus, over one year, Bond A would yield $20.01 = $10 + ($10 * (1.01)), including $0.01 of interest on the first $10 coupon reinvested for another six months. The annual return is 2.01% = effect(2%, 2), but SEC yield doubles the semi-annual return of 1.00% to get 2.00%, in order to match the rate on the bond.

If yields change

Six months later, the yields are now 2.1% (9.5-years until maturity). Bond A will be worth $991.43 = PV(2.1%/2,19,10,1000,0), for a total return of $1.43 = (10 - (1000 - 991.43)) which is 0.14% of its value. Bond B will be worth $1077.15 = PV(2.1%/2,19,15,1000,0), for a total return of $1.92 = (15 - (1090.23 - 1077.15)) which is 0.18% of its value.

Alternatively, suppose that yields in 6 months are now 1.90%. Bond A will be worth $1008.65 = PV(1.9%/2,19,10,1000,0), for a total return of $18.65 = (10 + (1008.65 - 10000)) which is 1.87% of its value. Bond B will be worth $1095.20 = PV(1.9%/2,19,15,1000,0), for a total return of $19.97 = (15 + (1095.20- 1090.23)) - which is 1.83% of its value.

The same yield change thus results in almost the same total return change for both bonds. The reason that the total returns are not exactly equal is that Bond B has a shorter duration. More of its value is from the coupon payments, which are made in less than ten years and are thus less affected by changing rates. If two bonds have equal durations, their total returns will have identical response to small changes in rates (but not necessarily to larger changes because of convexity).

SEC yield versus distribution yield

Many sources report a distribution yield for a fund, based on the distributions it actually made. The SEC yield is a better estimate of future returns. The distribution yield is a better estimate of the types of returns (dividends versus capital appreciation or depreciation), which may affect the taxability of those returns.

The calculation of distribution yield is not standardized, but a common definition is the ratio of distributions over the last year to the fund price. Bond A has a 2.00% distribution yield, and Bond B has a 2.75% distribution yield. Regardless of what happens to yields, Bond A and Bond B will have almost the same total return, as shown in the examples above. Bond B will pay a higher dividend, but will rise less or fall more in price for any change in rates.

Using SEC yield to forecast returns

The SEC yield will only equal the return of a fund over a future time period if the yields on the bonds in that fund keep the same yield. For example, if a fund holds ten-year bonds, and next year's yields on nine-year bonds are the same as today's yields on ten-year bonds, then next year's return should equal the SEC yield. If investors expect the yield on a bond to rise or fall in the future, they expect a lower or higher return than the SEC yield.

In particular, if the yield curve is inverted, with longer-term bonds yielding less than shorter-term bonds, investors must expect yields to rise. Since a ten-year bond has significant interest-rate risk, investors are likely to buy ten-year bonds only if they expect higher one-year returns than on one-year bonds. If ten-year yields are lower than one-year yields, it is likely that nine-year yields next year will be lower than ten-year yields today, and investors expect returns on long-term bond funds to exceed SEC yields next year. Conversely, if the yield curve is very steep, investors expect returns on long-term bond funds to be lower than SEC yields.

Cautions for specific types of bonds

For some types of bonds and funds, the SEC yield is not a good indication of future returns. Some fund providers, including Vanguard [3], include these cautions in links to SEC yield information.

For high-yield bonds, the yield to maturity is higher than the expected return for holding bonds to maturity, because many high-yield bonds will default. Even if yields do not change, the return on a high-yield bond fund will be less than the SEC yield. (There is a similar but much smaller effect for investment-grade corporate and municipal bonds. If the default risk on a bond increases, the bond price will decline. The fund may sell the downgraded bond for a loss, or hold it and possibly take a larger loss if the bond defaults.)

For mortgage-backed bonds such as GNMAs, the SEC yield does not reflect prepayment risk. If mortgage rates decline, homeowners will refinance their mortgages, causing the principal to be paid out and forcing the fund to reinvest at lower yields. This is analogous to the call provision on many other bonds. The SEC yield can adjust for callable bonds by using the yield to call if a bond is likely to be called, but it cannot adjust for mortgage-backed bonds because mortgages can be called at any time (upon refinance, or when the home is sold).

For foreign-currency bonds, the SEC yield is based on the yield in the foreign currency. For example, if a euro bond has a 1% yield, the fund uses that 1% for the SEC yield. If the dollar falls by 2% against the euro, a US investor would earn 3.02% in dollars. If investors expect the dollar to fall by 2% against the euro, the fund can guarantee the 3.02% return by currency hedging, but will still report the 1% SEC yield.

For TIPS, the reported SEC yield may or may not include the inflation adjustment. If a TIPS yields 1% above inflation, and inflation last year was 2%, the fund could report an SEC yield of 1% above inflation, or 3.02% total. (Vanguard does not include the inflation adjustment.) When comparing TIPS funds, check that the definitions used are the same.

For a fund-of-funds holding bond funds, the SEC yield uses the distribution yield of the bond funds, as if they were stocks paying dividends. For example, Vanguard Total Corporate Bond ETF (VTC) holds Vanguard's short-term, intermediate-term, and long-term corporate ETFs. If the individual ETFs have higher distributions than their SEC yields (because the prices of their bonds fell and the yields rose since the ETFs bought them), then VTC will have a higher SEC yield than the yield to maturity. Vanguard does not include a caution about this difference, although it can be recognized because the SEC yield of VTC is computed by the formula for stock funds.

SEC yield as an estimate of risk

Since investors trade bonds at prices which give an adequate compensation for risk, the yield to maturity of a bond is a good estimate for the relative risk of the bond, as estimated by the market. The SEC yield plus the fund expense ratio is the yield to maturity. If two funds of the same duration and bond type have bonds with different yields to maturity, the fund holding higher-yielding bonds presumably has higher credit or call risk.

Duration risk is not necessarily reflected in the SEC yield. If the yield curve is inverted, long-term bonds have lower SEC yields than short-term bonds because investors expect rates to fall, but the long-term bonds still have more interest-rate risk.

For comparing bonds of different types, the market price and thus the SEC yield are also affected by the tax treatment. A municipal bond with a 3% yield and a corporate bond with a 4% yield could have comparable risk, as investors with marginal tax rates over 25% would prefer to buy the municipal bond, while tax-sheltered investors or those with lower tax rates would prefer to buy the corporate bond.

Stock funds

For a stock fund, the SEC yield is useful for estimating tax costs, and understanding the type of stocks held by a fund. It is not useful in estimating future returns once the expense ratio has been taken into account.

The SEC yield of a stock fund is the dividend yield, minus the expense ratio. A fund with a high SEC yield thus holds high-dividend stocks, which may or may not have higher total returns. If the fund is held in a taxable account, the high dividend yield will lead to a higher tax bill, although this also depends on how much of the dividend is qualified.

Distribution yield of a stock fund

The distribution yield of a stock fund is based on the previous dividends (usually for the last year), while the SEC yield is based on the current dividend yield. These should usually be close. They may be different if stock yields changed, or if the fund recently bought higher-dividend or lower-dividend stocks.

If a fund is growing, its SEC yield may be higher than its distribution yield, particularly if the fund pays dividends infrequently. Consider a fund which had $160M in stocks a year ago, growing to $200M when it distributed its last dividend, holding stocks with a 2% dividend yield. The SEC yield is 2.00%. If the dividends are paid annually, it had an average of $180M in stocks on their dividend dates, so it received $3.6M in dividends and will report a 1.80% distribution yield. If the dividends are paid quarterly, the fourth-quarter dividend was based on an average holding of $195M in stocks, and was thus $0.975M ($3.9M annualized), so the fund will report a 1.95% distribution yield for the fourth quarter, and a similar yield for the full year if the growth rate was consistent.

See also

Notes

  1. The formula is described in Bond yield. The calculation can also be done with a spreadsheet as -$1,090.23 =PV(1%,20,15,1000,0). The negative sign in the result indicates the direction of cash flow.

References

  1. Vanguard definition of SEC yield
  2. 2.0 2.1 SEC Registration form for open-end investment companies (formula on PDF pages 69-70, printed pages 58-59))
  3. Vanguard mutual funds list; click on the links in the SEC yield for high-yield, GNMA, international bond, and TIPS funds to see the cautions