(PUB) Investing 2015

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When a Fund’s Yield Flashes Red Income Strategist | Michael Herbst

agement’s willingness to take recent gains from its high-yield stake (though the fund held 19 . 9% of assets in equities as of January). We also looked for funds exhibiting negative net asset value growth over that trailing five-year period, as eroding NAV s can jeopardize a fund’s ability to sustain its income distributions. The negative NAV growth of PIMCO Emerging Local Bond PELBX and T. Rowe Price Inter- national Bond RPIBX bears watching but is under- standable given the recent strong U.S. dollar rally and turmoil in Russia and Brazil. The higher volatility of unhedged world- or emerging-markets-bond funds also increases the risk that squeamish investors might sell the funds at the wrong time, thus locking in losses. Should those funds find themselves digging their way out of a deep hole, they may be less able to support their income distributions over the longer term. Total return is the best way to tally gains from income and NAV growth, but the tepid NAV growth of the other funds above (shown in nominal terms) raises a broader concern for income-oriented investors. In real (or after-inflation) terms, those nominal NAV returns start to dip further into negative territory—inflation returning to or exceeding the long-term 2 . 5% – 3 . 0% historical average could impair the purchasing power of their future income streams. The solution to that quandary is beyond the scope of this article, but the quandary itself is worth highlighting. By design, the Morningstar 500 excludes funds that consistently stretch for yield or erode their NAV over time. Yet given abnormally high valuations across broad swaths of the fixed-income markets, we wanted to take the funds’ temperature. Investors would do well to apply these tests to other income- oriented funds they are considering in order to flag those that risk the permanent loss of capital in the pursuit of above-average yields. œ

As yields across most of the market remain low, income-seeking investors may be increasingly tempted to stretch for yield. We looked for signs of trouble in recent yields of the 85 funds in the Morningstar 500 that make monthly income distri- butions. Fund yields tend to reflect the broader market—for instance, significant quantitative eas- ing in the United States, eurozone, and Japan in recent years has pumped up bond prices, thereby depressing these funds’ yields. Beyond that, each fund’s strategy and risk profile will shape its yield, making it tougher to draw conclusions across groups of disparate funds. We often keep an eye out for funds with eye-popping yields, as they can signal that a fund has taken on big doses of credit or liquidity risk. For this group, however, we took a different tack. We first looked for funds whose 12 -month yield as of February 2015 was significantly lower than their median 12 -month yield over the trailing five-year period, as evidence they may be holding big chunks of high-priced or low- coupon bonds, which may leave them more suscep- tible if yields rise suddenly. The funds sporting the lowest yields relative to the longer trailing period have generally pulled in the reins as of late. As nonagency mortgage-backed securities have rallied in recent years, the team backing TCW Total Return Bond TGLMX and Metropolitan West Total Return Bond MWTRX has taken gains and built up larger-than-usual stakes in U.S. government fare as ballast and dry powder for future opportunities. Unlike some peers, neither Vanguard Short-Term Tax Exempt VWSTX or the periodically aggressive Wells Fargo Advantage Short-Term Municipal Bond STSMX has loaded up on longer-maturity or lower-quality bonds to eke out extra yield. The relative decline of Fidelity Capital & Income ’s FAGIX yield reflects man-

Contact Michael Herbst at michael.herbst@morningstar.com