Reading The Future

When it comes to fixed income funds, there is a very simple way of estimating your future return: look at the average market yield of the individual bonds that constitute the portfolio, net of management expenses (MER).  By market yield, we mean the average interest rate of all the bonds that constitute a fund’s portfolio.   For example, if you know that your fund invests in a basket of bonds with an average market yield of 6%, and if you also know that your fund’s MER is 1% p.a., you could forecast with a fair degree of certainty that this fund’s average return for the intermediate term will be in the vicinity of 5%.

It is as simple as that, and there is no need for you to waste too much time analyzing historical performance data.  Of course, most fund companies will tell you that this is an oversimplification, and that your portfolio manager will add value by playing the yield curve.   In theory, this is true.  But in practice, it seems to be rarely the case.  Fund managers know that playing the yield curve is a dangerous game.  They also know that there is a scarce supply of investment grade corporate and government bonds in the market.  So they tend to keep stable portfolios.  This is why there is a very limited potential for value-added from active portfolio management.  For most fixed income funds, the most important factor that determines future returns is the portfolio market yield, less MER (referred to as "Net Yield").

How do you obtain each fund’s average portfolio yield and duration? The best source, as usual, is the fund company itself.  Make sure, however, to obtain the portfolio’s market yield and not the nominal yield.  There is an important difference between the two: the nominal yield represents the original coupon rate of the underlying bonds and is completely irrelevant for your purposes.  The market yield reflects the actual interest that you will be collecting, as determined by the market price you pay for the bond.

 There is also an acceptable alternative for estimating a fund’s average market yield (net of expenses), which is to use its interest income distribution of the most recent year as a proxy.  For example, if a fund distributed income at a certain percentage of its value, say 1% last quarter, you can infer that its average portfolio yield was about 4% per annum.  Of course, the yield may since have changed by quarter or half per cent, but that would have applied to all other funds in the category. Do not be fooled by historical performance data, or promisses of spectacular returns: they simply don't matter.

 A note of caution: keep in mind that the aforementioned technique for projecting future returns assumes that all bonds will be paid at maturity by their issuers.  This is a fairly safe assumption to make when your fund invests in investment grade bonds, such as those issued by federal and provincial governments, or by top class corporations.  Most Canadian bond and mortgage funds fall under this category.   However, when it comes to high yield bonds (more commonly known as junk bonds), the rules of the game become totally different, because you would have to take default risk into account.