2 Key Numbers to Understanding Bond Funds
Get to know your bond funds by learning about these important data points.
Yes, yields could fall further. That would be a boon for investors because bond prices move inversely with interest rates. But let's get real: Rates can't fall below 0%, and they could theoretically rise to the moon.
All the more reason that investors must know about duration, which measures a bond's sensitivity to interest-rate moves. The higher the duration, which is measured in years, the more a bond's price will change with moves in interest rates. For example, a duration of 5 means that for every percentage-point rise in rates, a bond will lose roughly 5% of its value (and gain 5% for every percentage-point decline in rates).
Generally, the longer a bond's term, the longer its duration and the greater its yield. So the average duration of funds that invest in short-term bonds is shorter than the average duration of funds that own long-term bonds. Nowadays, the prudent course is to focus on funds with short durations (less than 6), even if it means accepting low yields. You can usually find duration at a fund's Web site.
Another important number is the 30-day yield, or SEC yield (SEC stands for the Securities and Exchange Commission). This is a standardized number meant to help investors compare income rates among different bond funds by looking at the yield to maturity of a fund's holdings. YTM recognizes that bonds that currently sell for more or less than face value will pay off at face value when they mature. The SEC yield differs from a fund's distribution rate, which takes a year's worth of payouts and divides by the current share price. Distribution yields are typically better than SEC yields at indicating what a fund is paying currently, but SEC yields do a better job of forecasting what a fund will pay out in the coming year or so.