Running yield, also known as current yield, is a measure of the income generated by an income-generating asset, such as bonds or dividend-paying stocks, expressed as a percentage of the asset’s current market price.
Within the context of a bond, it is calculated as follows:
What Running Yield Doesn’t Tell You:
Running yield does not equal the expected return
- Ignoring total return: running yield only takes into account the income generated by the fund’s holdings relative to the current market price. It ignores the potential for capital appreciation or depreciation of the underlying assets. Funds with higher running yields may have lower potential for capital appreciation, and vice versa. Focusing solely on running yield might cause you to miss out on the overall potential return from both income and capital appreciation.
- Market conditions: The quoted yield assumes a stable interest rate environment but the interest rate environment is not stable. Movements in interest rates can impact the fund’s yield and overall performance.
- Market price volatility: The market price of income-generating assets can be volatile and not accurately reflect the fundamental value of the assets. A sudden drop in the market price of an asset can lead to a higher running yield, making the invest appear more attractive than it actually is.
- Point in time estimate: Bond holdings mature and portfolio managers may sell a low yielding instrument and purchase a high yielding instrument. When things change, so does the yield.
- The composition of a fund matters: Specifically, its exposure to fixed or floating-rate securities, plays an important role. Let’s unpack this in a bit more detail:
Fixed Rate vs. Floating Rate Exposure:
Generally speaking, a fund with more fixed rate exposure can be more susceptible to changes in yield compared to an income fund with more floating rate exposure. This is because fixed rate and floating rate securities respond differently to changes in interest rates.
Fixed Rate Bonds:
- If interest rates in the market rise, newly issued bonds will offer higher coupon rates, making existing fixed rate bonds with lower coupons less attractive. As a result, the market price of these fixed rate bonds could decrease, leading to a potential increase in the running yield of the fund.
- Conversely, if interest rates fall, the market price of existing fixed rate bonds could rise, leading to a potential decrease in the running yield.
Floating Rate Bonds:
- A fund with higher exposure to floating rate securities, such as floating rate bonds, is more insulated from interest rate changes. Floating rate securities typically have their coupon rates reset periodically based on a benchmark interest rate (e.g., JIBAR), which means that their interest payments adjust in response to changes in market interest rates. As a result, when market interest rates rise, the coupon payments on floating securities also increase, helping to mitigate the impact of rising rates on the running yield of the fund.
In summary, a fund with more fixed rate exposure is generally more sensitive to changes in interest rates, which can lead to fluctuations in its running yield as interest rates change.
The Impact of Duration on Yield:
The running yield of a fund can also be more susceptible to change if it has higher duration. Duration is a measure of sensitivity of a bond’s price to changes in interest rates. The longer the duration, the more the bond’s price is likely to change in response to interest rate fluctuations, which in turn, leads to greater variation in the fund’s quoted yield.
Consider two funds, both quoting a 9% yield. Fund A holds floating rate notes, while Fund B holds a diversified basket of floating and fixed rate instruments, including longer-dated (higher duration) fixed rate bonds.
- All else being equal, should there be a parallel upward shift in the yield curve – a parallel shift occurs when the interest rates on all fixed income maturities increase or decrease by the same number of basis points – fund B will likely underperform Fund A and the 9% quoted yield, as the prices of fixed longer dates bonds will fall more than that of shorter dated fixed rate bond or floating rate bonds as the yields to maturity rises.
- However, should interest rates fall, the opposite will occur, Fund B will outperform fund A due to the fact that the price of the longer dated fixed rate bonds will increase more than that of the floating rate bonds as the yields to maturity falls.
- In summary, even though these two funds have the same quoted yields, they will perform very differently if they are positioned differently, which means that you cannot rely on a quoted yield to try and determine the expected return of the fund.
Running yield should not be the sole basis for investment decisions
Running yield does not provide a complete picture of an investment’s overall risk and return profile and is subject to the following limitations:
- Liquidity risk: Higher running yields may indicate that the underlying investments are less liquid.
- Credit risk: Higher running yields might indicate investments with lower credit ratings and higher credit risk. Bonds with higher yields often belong to issuers with weaker credit quality.
- Interest rate risk: The running yield does not account for changes in interest rates, which can significantly impact the value of fixed income investments. If interest rates rise, the market value of existing bonds may decrease, affecting the overall return.
What yield does tell you:
The below table reflects the duration and quoted yield of three different income funds, each yielding more or less the same. By comparing these numbers, you can get a good idea of how each of these funds are positioned and what risks, as well as how much risk the funds are exposed to.
- Fund A has the lowest duration, but a similar yield to Fund B and C. In order to achieve a similar yield to that of its peers with much less duration, it must take have exposure to more credit and liquidity risk. It would be safe to assume that fund A is taking on more credit risk to generate the higher yield.
Let’s break this down:
- Low duration: a low duration suggest that the fund’s portfolio is less sensitive to interest rate fluctuations. This could mean that the fund holds shorter-term bonds or bondS with variable interest rates, which generally have lower durations. In South Africa, the majority of credit is floating rate.
- High yield: A high yield implies that the fund is investing in higher-yielding securities, which could include bonds with lower credit ratings (higher risk of default) or other non-traditional income generating assets.
- Fund B has less duration compared to fund C, but offers a similar yield. This means that the portfolio is less sensitive to interest rate fluctuations compared to fund C. However, it also means that there is more credit and liquidity risk in the portfolio compared to fund C. Given the higher duration of fund C, but similar yield to that offered by its peers, it is safe to assume that the credit held by fund C is of superior quality to that of its peers.
When comparing the quoted yields of different funds, exercise caution in interpreting them. Avoid the misconception that the quoted yield directly represents the anticipated return the fund will provide. However, leveraging this information can be valuable in assessing the specific risks to which the fund is exposed and gauging the extent of risk undertaken by the fund.