Common mortals are left to wonder which is worse--- pathetic yields, or rising yields?
In fact, what each of us would like is the maximum possible yield with the least possible risk.
How do we do it?
In fixed income mutual funds we can do it with a simple test that involves just two readily available numbers. The numbers are available from the mutual fund companies themselves. They are also available by a visit to the Morningstar website, http://www.morningstar.com/. The Chicago investment data firm regularly surveys mutual fund companies for fund data.
The first number is the 30-day SEC yield. This tells us what the annual yield rate was in the previous 30 days. The SEC requires that the calculation account for premiums and discounts on securities that may affect the true yield of the investment. This figure is a more accurate representation of the portfolios' yield than the trailing 12-month distribution figure.
The second number is the duration of the portfolio. While average maturity is a reasonable proxy for interest rate risk, duration is a more accurate measure. It reflects the impact of interest payments. A high yield bond fund with a 10-year average maturity, for instance, has less interest rate risk than a tax-free bond fund with the same maturity. The difference is the amount of interest paid each year. (Both junk bonds and tax-free bonds also have an element of credit risk. This column only considers funds that invest in secure government securities.)
Basically, the duration of the portfolio tells you how much the value of the fund will rise or fall if interest rates change. Duration of 3, for instance, means the value of a portfolio will rise or fall by 3 percent if interest rates change by 1 percentage point. A portfolio duration of 6 has twice the interest rate risk as a portfolio duration of 3--- and six times the interest rate risk as a fund with a duration of 1.
A dream portfolio would have no credit risk, a high yield, and a low duration. Alas, the dream portfolio does not exist. But some portfolios will treat you better than others if interest rates rise. If you subtract the duration from the SEC yield you have a good approximation for what the total return for a fund would be if interest rates rose by one percentage point.
Vanguard Long Term U.S. Treasury fund holds long term bonds and has a duration of 10, according to Morningstar data. It also has an SEC yield of 4.54 percent. Subtract the duration from the yield and you get a one-year total return of MINUS 5.46 percent. If you're expecting interest rates to rise, this is not the fund to hold.
Vanguard Short Term Federal fund holds short term obligations and has a duration of 1.9. Subtract that from its 2.32 percent SEC yield and you get a one-year total return of 0.42 percent. Not great, but better than an actual loss.
What's the best bet for investors who want the highest possible current income with the least possible risk? To answer that I screened for the largest no load government securities funds that required minimum investments no greater than $50,000. Then I subtracted the duration from the SEC yield.
Vanguard GNMA. It's strong 5.27 percent SEC yield and low 1.9 duration would result in a total return of just over 3 percent if interest rates rose by 1 percentage point. Other funds that specialize in government mortgage securities also do well on this test.
|Test Your Fund For Interest Rate Risk|
|Find the two figures on your fund, subtract the duration from the yield, and you've got an estimate of the one year total return if rates rise by one percentage point.|
|Fund Name||30 day SEC yield||Less Duration=||Estimated 1 Yr. Total Return if Interest Rates Rise 1 Percent|
|Your FI Fund 1|
|Your FI Fund 2|
|Your FI Fund 3|