The Difference Between Bond Yield and Total Return
The primary purpose of most bond funds is to provide investors with income. But those who focus exclusively on a bond fund’s yield are only seeing part of the picture. Investors must also consider the fund’s total return, which is the combination of yield and the return provided by principal fluctuation.
Bond Yield vs. Return
Yield is the income that a fund pays on either a monthly or quarterly basis.
The investor can either take this income in the form of a check or reinvest it back into the fund to buy new shares. There are various ways to calculate yield, which can be a source of confusion to many investors, but these different numbers are explained in my article, What is a Distribution Yield? The bottom line is that if a fund’s share price didn’t change and it paid a 5% yield in a given year, the fund’s total return would be 5% for that year.
Unfortunately, it doesn’t always work that way in real life. In addition to the return provided by yield, the daily fluctuations in the share price (or “net asset value”) also make a contribution to total return. In a given year, these fluctuations can cause the total return to be higher or lower than the fund’s yield. If a fund that yields 5% also has a 5% increase in its share price, its total return is 10%. If the same fund experiences a 5% decline its share price, the total return is 0%.
Depending on the type of fund, these fluctuations can have varying degrees of impact on return. For instance, high-yield and emerging market bond funds tend to have much greater volatility than short-term bond funds that invest in higher-quality securities. Before investing in a fund, investors need to be sure they are comfortable with the potential volatility.
While a fund that invests in high yield bonds will usually have a higher yield than another bond fund that invests in higher-quality securities, the amount of principal fluctuation may not be appropriate for investors with low-risk tolerance or who may need the money in the near future.
How Capital Gains Distributions Affect a Bond Fund’s Return
Each year, many funds pay out capital gains on the money they have made from buying and selling securities. This is a complicated issue, but you there are some important highlights to keep in mind:
- Capital gains result in an equivalent reduction in the fund’s share price (i.e., a fund with a $10 share price that pays a 20-cent distribution will see its share price drop to $9.80). Despite the drop in share price, the total return is unchanged because you've received the difference in the capital gains distribution.
- Investors can either reinvest the proceeds by buying more shares, or they can take the distributions as income. Either way, a person who holds a fund in a taxable account will usually have to pay taxes on the distribution – which means that the after-tax total return will be reduced by the amount of tax paid.
- The total returns quoted in the media and on fund companies’ websites assume the reinvestment of all dividends and capital gains.
- Unless you need the money to pay expenses, it’s preferable to reinvest distributions since it allows the power of compounding to work in your favor.
The Bottom Line
Investors need to take care not to confuse yield with total return. Just because a fund has a reported yield of 7% doesn’t mean that’s the actual return on your investment. In a given year, fluctuations in the bond fund's share price, the fund's capital gains distribution to its shareholders and the particulars of your own tax situation mean that your after-tax return will likely differ.
About Money does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.