Understanding Yields
When dealing with bond mutual funds, one of the more confusing topics tends to revolve around fund yields. There
seems to be a never-ending array of yields, including yield-to-maturity, distribution yield, indicated yield,
12-month yield, 7-day yield, and the list goes on. Interpreting yields adds to the confusion. For instance, the term
“yield” is often mistakenly translated to mean “income rate,” which is only correct in some instances. Hopefully,
this write-up will help clarify the definitions and interpretations of the most commonly utilized “yields” that are
reported in conjunction with the Dryden fixed income mutual funds.
CURRENT YIELD AND DISTRIBUTION YIELD
By its simplest definition, “yield” is the return an
investor receives on a bond (or bond fund) based on the
price paid and the coupon interest received. Yields can be
broken down into two basic classifications, current yield
and yield-to-maturity.
Current yield is the easiest type of yield to compute, and
is often the yield most investors (sometimes mistakenly)
focus on in evaluating the attractiveness of a specific
bond or bond fund. Current yield relates the annual
coupon interest received from a bond to its market price,
thus providing a reasonable estimate of the income
generated from the security at a specific point in time. It
considers only coupon interest, and does not account for
capital gains or losses that could be realized by the
investor, nor the effects of compounding as a result of
reinvested interest.
The formula for calculating current yield is as follows:
Current Yield = Annual dollar coupon interest/Price
When applied to bond funds the formula varies slightly
to account for the fact bond fund dividends are generally
not fixed.* Distribution yield is reported for the Dryden
bond funds to provide our investors with an estimate of
the income paid out by the fund. Distribution yield is
calculated by adding the trailing 12-months per share
dividend and dividing the sum by the Fund’s month-end
NAV. Morningstar and Lipper both provide a “12
Month Yield” to reflect distribution yield using a very
similar calculation.
The key difference between distribution yield and
current yield is that the distribution yield, by including
the past 12-months dividend payments, is backward
looking and should not be used to illustrate a fund’s
expected income going forward. As we know, in a falling
rate environment, bond prices rise. Since a bond’s price
is a key determinant of the distribution yield, falling
interest rates will impose downward pressure on the
distribution yield. Additionally, because funds are
actively traded, in a falling rate environment, lower
coupon bonds and/or high coupon bonds priced at
increasing premiums will be added to the portfolio,
adding further downward pressure on the distribution
yield. Since the reported distribution yield includes
monthly dividend payments up to 12 months old, the
reported yield can overestimate the distribution rate that
would more likely be realized by the investor at that
point in time. Of course, the reverse would transpire
during a rising rate environment.
A more timely indicator of a fund’s current distribution
rate is the 30-Day Yield (not to be confused with the 30Day SEC Yield discussed later), which is an annualized
yield based on the income paid out by the fund over just
the past 30 days, not the preceding 12 months.
Bloomberg provides a similar yield called Indicated
Yield. To calculate a 30-Day Yield or Indicated Yield,
simply annualize the past 30-days’ distributions, and
divide the product by the current fund price.
* Most bond funds pay floating rate dividends as opposed to fixed rate dividends. While an attractive feature to some investors, fixed rate dividends can force a fund’s manager
to focus on achieving the required yield, which can disrupt the fund’s appropriate risk/return profile. All Dryden bond funds are managed with an emphasis on total return,
not distribution yield, and pay fluctuating dividends.
IFS-A086708
Calculating Current Yield and Distribution Yield
While the bond’s coupon is fixed, its current yield varies with the price of the bond or bond fund.
Years to maturity is not a factor in calculating current yield.
Example 1: Corporate Bond
Scenario 1
Purchase price = $1000 (par)
Annual Coupon = $80 (8%)
Current Yield = $80/$1000 = 8%
ABC Corporation,
8.00%; 06/15/2013
Scenario 2
Purchase price = $900
Annual Coupon = $80 (8%)
Current Yield = $80/$900 = 8.89%
Example 2: XYZ Bond Fund
NAV
Monthly Per Share Dividends
= $11.50
Distribution Yield
= $0.545391 (12 month dividend total)
$11.50
(NAV)
= 4.74%
30-Day, or Indicated Yield
(as of 9/30/03)
= 0.047012 x 12
= 4.91%
11.50
31-Oct-02
0.046459
30-Nov-02
0.047001
31-Dec-02
0.059619
31-Jan-03
0.032176
28-Feb-03
0.049420
31-Mar-03
0.041239
30-Apr-03
0.045072
31-May-03
0.043782
30-Jun-03
0.044390
31-Jul-03
0.045214
31-Aug-03
0.044007
30-Sep-03
0.047012
12 Month
0.545391
YIELD-TO-MATURITY AND 30-DAY SEC YIELD
As noted above, the current yield and distribution yield
provide rough estimates of the expected income rate of a
bond or bond fund at a point in time. However, these
yields do not take into account the potential impact of
changes in interest rates. A more comprehensive yield
calculation that does take this into account is Yield-toMaturity, or as it applies to mutual fund products, the
30-Day SEC Yield.
Yield-to-Maturity (YTM) reflects the internal annual
rate of return an investor would realize by purchasing a
bond, holding it to maturity and reinvesting all coupon
interest received at the same YTM. Another way to think
about YTM is as the interest rate that will make the
present value of the bond’s cash flows equal to its
purchase price. Unlike the current yield, YTM does
incorporate the capital gain/loss the investor would
experience on the purchase price, as well as the
contribution of reinvested dividends. Therefore, if a
bond is purchased at a premium (i.e. market yields are
lower than the bond’s coupon rate), its yield-to-maturity
will be less than its coupon rate because the investor
would realize a capital loss on the bond when it matures
at face value (par) and would be reinvesting coupons at
lower rates over time. Conversely, if the bond is
purchased at a discount (i.e. market yields are higher
than the bond’s coupon rate), its yield-to-maturity will be
higher than its coupon rate. Additionally, it is forward
looking, as opposed to the current yield that looks
backward, and is considered a more accurate indication
of the return the investor will experience. It also allows
you to compare bonds with different maturities and
coupons. Please see the call out box on the next page for
an illustration on determining yield-to-maturity.
Yield to Maturity
Yield-to-Maturity is the interest rate that will make a bond’s price equal to the sum of its cash flows. It is
generally calculated using a financial calculator – it is not solvable through simple arithmetic. Consider the
example of a 5-Year, 6% Coupon Bond:
Current Coupon Bond
(market rate = coupon rate)
Premium Bond
(market rate < coupon rate)
Discount Bond
(market rate > coupon rate)
Bond Price = $100.00
Yield to Maturity = 6%
Bond Price = $104.33
Yield to Maturity = 5%
Bond Price = $95.90
Yield to Maturity = 7%
Period
Cash
Flows
Present Value*
(@ 6%)
Present Value*
(@ 5%)
Present Value*
(@7%)
1
$6.00
$5.66
$5.71
$5.61
2
$6.00
$5.34
$5.44
$5.24
3
$6.00
$5.04
$5.18
$4.90
4
$6.00
$4.75
$4.94
$4.58
5
$106.00
$79.21
$83.05
$75.58
Bond Price =
$100.00
$104.33
$95.90
* Present Value = Future Value [1/(1+i)N], where i = interest rate, and N = number of periods.
Yield-to-call is calculated the same way, however it
assumes that a callable bond that is purchased at a
premium will be called (i.e. the investor will receive face
value) on the bond’s call date. Sometimes the term “yieldto-worst” is used to ensure that the investor is looking at
the most conservative scenario in evaluating a bond. The
“yield-to-worst” is the lower of the yield-to-call and
yield-to-maturity.
The 30-Day SEC Yield is similar to the yield-to-maturity
and is reported for mutual funds. It was introduced by
the SEC as a means of standardizing reported yields
across all funds to foster a fair, “apples-to-apples”
comparison and eliminate misleading performance and
income claims. While the formula for computing the 30Day SEC Yield is quite complex and beyond the scope of
this writing, the statistic is similar to yield-to-maturity,
and includes fund fees and expenses.*
* The formula for 30-Day SEC Yield is as follows: Yield = 2
[(
a-b +1
cd
) ]
6 -1
a = Dividend and interest income
b = Expenses accrued for the period (net of expense reimbursement)
c = Average daily number of shares outstanding during the period that was entitled
to receive dividends
d = Maximum offering price per share on the last day of the period
Interpreting Yields
Case Study: Dryden Total Return Bond Fund
As of September 30, 2003, the Dryden Total Return
Bond Fund’s (A shares) distribution yield (at NAV) and
30-Day SEC Yield are 4.52% and 2.83%, respectively.
Why are these yields so different? The answer lies in the
composition of the Fund’s holdings. Since the
distribution yield exceeds the 30-Day SEC Yield, the
likely explanation is that the fund holds high coupon
bonds priced at a premium. This is in fact the case with
the Dryden Total Return Bond Fund, as reflected by
the fund’s average price of 102.968 (par = 100). The
portfolio’s holdings have increased in value as market
rates have fallen, while premium prices have been paid
to acquire new securities whose coupon rates exceed
those available in the current market. As a result, the
fund’s distribution yield (which only considers income
paid) is high relative to its 30-Day SEC Yield (which is
based on yield-to-maturity).
In general, after a prolonged period of falling interest
rates, as we’ve experienced from 2000 through 2003,
many funds will likely show distribution yields that are
higher than their 30-Day SEC yields. This is logical,
since bond prices rise as interest rates fall. Their coupon
rates, however, have remained constant while the bonds’
prices have risen as interest rates have trended down.
The reverse can be expected following a rising rate cycle.
As of September 30, 2003, the Dryden Total Return Bond
Fund’s A share average annual total returns were as follows:
1-year: 3.50%,5-year: 4.51%, since inception (1/10/1995)
6.90%. The Fund may invest up to 50% in high yield, or
“junk” bonds, which are subject to greater credit or
market risks. The Fund may invest up to 45% in
foreign securities, which are subject to the risks of currency
fluctuation and the impact of social, political and economic
change. Mortgage-backed securities are subject to prepayment
and extension risks. These risks may result in greater share
price volatility. Past performance does not guarantee future
results and current performance may be lower or higher
than the performance data quoted. The investment return
and principal value will fluctuate and shares when sold may
be worth more or less than the original cost. For more
information about the Dryden Total Return Bond Fund
and for a free prospectus, call your financial professional.
You should consider the fund's investment objectives, risks,
and charges and expenses carefully before investing. The
prospectus will contain this and other information about the
investment company. Please read the prospectus carefully
before investing. Shares of the fund are distributed by
Prudential Investment Management Services LLC (PIMS).
PIMS is a Prudential Financial company and member
SIPC. JennisonDryden is a service mark of The Prudential
Insurance Company of America.
SUMMARY
S
o, what should investors focus on, Distribution Yield
or 30-Day SEC Yield? This will depend on the investor’s
objective and time horizon. Investors with a very short
term time horizon (less than a few months) may find the
distribution yield to be useful, since they might only
focus on the dividend payments for a few months and
may be willing to assume that the markets will not
fluctuate significantly during this time. Similarly,
income-oriented investors who receive cash distributions
and depend on a consistent monthly payment may find
it meaningful since it reflects only the distributions they
can expect to receive. But remember, most funds’
dividend rates are not fixed, so the distribution yield
should be used only as a guideline to approximate the
expected cash flows for the next month or two. Further,
and more importantly, dividend distributions tell only
part of the story for bond fund returns. Any investor who
is planning to hold a bond fund over time should look at
both dividends and capital gains and losses.
As such, the 30-Day SEC Yield is a more accurate
estimator of the return an investor will experience with
his or her bond fund investment over a longer period of
time. Remember, total return matters with bond fund
investments. Many dynamic factors such as interest rates
and credit fundamentals affect the value of a bond or
bond fund, and the 30-Day SEC Yield incorporates these
factors into its calculation. Additionally, because of its
standardized formula, the 30-Day SEC Yield can be used
to compare funds when making investment choices. We
suggest that all investors, including those with income
objectives, consider the 30-Day SEC Yield when
selecting bond mutual funds, while using the
distribution yield to estimate the current monthly
distributions only where applicable for certain investors.
The comments, opinions and estimates contained herein are based on or derived from publicly available information from sources that Prudential Fixed Income believes to be reliable. This outlook,
which is for informational purposes only, sets forth our views as of this date. The underlying assumptions and these views are subject to change.