Bond Funds Show High Yield Now, Low Income Later, Study Finds

Fixed-income 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 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, Kelly said. As these bonds approach maturity and continue to pay interest in the form of coupons or the equivalent cash, their prices fall toward par or face value, Kelly said.

If the fund pays out the bond’s full coupon to shareholders, then the fund must reduce its net asset value, or market price, to account for passing along the interest payment, Kelly said. As money is paid to shareholders, the fund has less money with which to buy more income-producing assets, Kelly said.

Some funds don’t pay out the entire dividend to shareholders, and as such, their net asset value is less affected, Kelly said.

Unlike most stock fund investors, who tend to leave their dividends and capital appreciation in the funds, most bond fund investors tend to take out their income.

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, high-yielding bonds were Franklin U.S. Government Securities Series Fund and Van Kampen American Capital Government Securities Fund, Kelly said. The fund that offered a high yield and also saw its net asset value appreciate in the five-year period was FPA New Income Fund, he said.

Managers of FPA New Income didn’t distribute the fund’s full yield, Kelly said. Instead, the managers amortized, effectively retaining, a portion of the bonds’ coupon payments before distributing the income, 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.

“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.

“Identifying the income champs of tomorrow isn’t an easy or definitive process,” he said. “We can nonetheless offer a few clues.”

People who want high yields should consider buying funds that invest in long-term bonds, Kelly said. Bonds with longer maturities tend to pay out more income. These bonds also can be more risky since they lose value faster than short-term bonds when interest rates rise.

Yield-hungry investors should target 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.

Investors should be wary about buying funds that own “lower-quality” bonds to boost yield, Kelly said. Some fund shareholders, for instance, were burned in recent years because of investments in emerging market debt, he said, which ultimately plunged in value in 1994 after the Mexican government devalued its currency.

Finally, investors would be better off owning funds that use “intelligent accounting practices”--or amortize--to help preserve market value, Kelly said.

“In sum, it always make sense to look beyond bond funds’ current yields--even when income is the main goal,” Kelly said.