"I'm invested in bond funds and discovered there are two yields: the SEC yield and the dividend distribution rate," a reader writes. "The SEC yield is supposed to be more meaningful, but most funds' phone advisers can't explain it.
"Since I invest only for distributions, what concern should I have for the SEC yield? Does the SEC have a leaflet on it?"
No. But the Securities and Exchange Commission, which regulates mutual funds, does provide fund companies instructions on how to calculate it. They can be summarized without too much trouble.
By understanding the differences in how the two figures are computed, you can understand how you should regard them when you check on bond funds -- and why one is occasionally much higher than the other.
A fund's dividend distribution rate -- long referred to as its yield -- represents a fairly simple concept. it's the total of income dividends paid during a 12-month period, divided by the net asset value (NAV) of the fund's shares at the end of the period.
The rate fluctuates as dividends and NAVs change with a fund's net income and the market value of its portfolio.
Offsetting that simplicity is a major shortcoming: The rate may be misleading. It can be inflated by fund sponsors who, believing the old adage that "yield sells," invest in high-yield securities that expose shareholders to an unexpected risk of losing some capital.
Such distribution-boosting tactics -- and the promotion of claims for yields that weren't uniformly calculated -- led the SEC to blow the whistle in 1988.
"To prevent misleading performance claims by funds and to permit investors to make meaningful comparisons among fund performance claims in advertisements," the SEC introduced the uniformly calculated, annualized 30-day yield for ads and other uses.
The SEC asked funds to describe the calculation briefly in their prospectuses.
The formula, based on proposals by the Investment Company Institute, calls for dividing the net investment income a fund earned per share during a 30-day period by its maximum offering price (MOP) per share on the last day of the period.
The difference between this divisor and that of the distribution rate is easy to spot. The MOP of a fund with a front-end load is the total of its NAV and sales charge whereas the MOP for a no-load fund or one with a deferred sales charge is the NAV alone.
(If you're in a fund with a deferred sales charge, keep in mind its potential impact.)
So, all other things being equal, the 30-day yield of a fund with a front-end load would be lower than its distribution rate, whose calculation uses only the NAV as the divisor.
It's in the computation of net investment income, however, that less obvious -- but important -- differences lie:
* Interest income. When interest rates fall, as in the recent past, the annualized rate of interest income earned in the latest 30 days should be lower than that of the latest 12 months.
* Amortization of premium and discount. For every bond in a fund's portfolio that sells at a premium because its coupon interest rate exceeds market levels, income must be regularly reduced by an amount that provides for the bond's market value returning to its face value by maturity. Similarly, for every bond selling at a discount, income must be adjusted to provide for its increase to par.
* Calls. Premiums of bonds subject to calls by their issuers must be amortized by the next call dates, instead of maturities.
* Mortgage-backed securities. Funds owning mortgage-backed securities, such as Government National Mortgage Association issues, receive principal repayments in monthly installments -- and may realize losses in connection with them. But they can't be certain how fast repayments may accelerate during periods of falling interest rates.
The SEC has given them a choice: to amortize premiums and discounts or not to amortize them. So, two funds with identical portfolios and costs could have different yields because of different policies for adjusting investment income.
Whether or not the 30-day yield resembles what a fund pays you, comparing it with the distribution rate and asking the fund company to explain substantial differences can be useful. You may learn more about the fund's policies and its suitability for you.
But remember, neither yield is as important as total return, which reflects both distributions (as reinvested) and NAV change -- and which, the SEC stipulates, must be featured along with yield.
"If you have to focus on one number, that's the one," says Robert S. Dow, who, in managing the Lord Abbett U.S. Government Securities Fund to provide relatively stable dividend income, owns a variety of issues that include high-coupon securities selling at premiums.
Owing partly to premium amortization, the fund's 30-day yield was only 4 percent as of Aug. 31 -- similar to those reported by some other government securities funds and a lot less than its 8.2 percent distribution rate.
The 12-month total return was 11.6 percent, reflecting respectable income for this period as well as some appreciation.