The Misconception Behind Bond Fund Distributions

Wednesday, February 1, 2012

Over the last five years the current coupon 5 year treasury note has fallen in yield from just under 5% to under 1% today (0.88% currently), while the income payout for many investment grade (IG) corporate bond funds (IGCB) has barely moved.  The income distributed by many of these funds is only modestly lower than 5 years ago.  A quick review of some of the larger, well known IGCB funds has shown that income distribution has only fallen on average about 20%, while bond yields as noted above have fallen in excess of 80%.

If you examine investment grade bond prices over this time period you see a similar pattern.  In October 2007, IBM issued a 5 year single A rated corporate bond to yield 5.05%, at a dollar price of 99.921.  Today IBM has an actively traded bond due in approximately 5 years (IBM 5.70% Due 9/17) which yields 1.57% or a dollar price of 121.853.  In other words, the yield on comparable maturity, same-issuer bonds has fallen by approximately 350 basis points, or nearly 70%.

How can IGCB funds continue to payout investment income at rates modestly lower than 5 years ago in light of the massive decline in government and corporate bond yields over the last 5 years?  Obviously we assume that decisions on how much income to distribute are being made in light of the underlying holdings and the income they produce.  But the question remains how are they producing this income in light of massively lower interest rates?

It would appear that, lacking a rabbit to pull out of their hats, the logical tools available to fixed income portfolio managers able to produce more income the old fashion way are – more duration (longer maturity bonds which pay more income) and lower credit quality (which also pay more income).  Unfortunately, reviewing funds that fall under the IGCB sector does not indicate that either duration is materially greater or that credit quality has fallen much in recent years.  Please note that these funds are somewhat restricted on duration and credit profile by the prospectus of the fund.

The only conclusion that can be drawn in our opinion is that unless interest rates make a quick and significant reversal (i.e. higher rates in the near term – which we do not believe will happen), these IGCB funds will need to continue to cut their investment income distributions in coming years.  Investors need to be aware of these potential lower yields on bond funds and factor this into their investment decisions.  Not only is lower investment income for these funds likely to occur, but fund prices (NAV) are also likely to fall.  Interest rates have little room to move lower and existing bond prices will be working their way from high premium prices back to face value in coming years.

In other words, when picking bond funds be very careful of any instrument that is likely to produce lower yields and falling bond prices in coming years.  Warren Buffett commented a few days ago that treasury securities should come with “warning labels”.  If so, many bond funds should come with “really large warning labels” – CAVEAT EMPTOR.