Fixed Income Mutual Funds and SMAs often quote current yield. The reason is that these collections of bonds do not have a finite maturity and/or their bonds are regularly traded. The yield-to-worst or yield-to-maturity calculations are difficult or impossible to quote because they are calculated based on a redemption date.
Individual bonds quote a yield-to-maturity (or if a premium bond is callable, yield-to-worst.)* The problem is that yield-to-maturity and current yield comparisons are an apples and oranges comparison. Yield-to-maturity calculates the income you will earn (present value of future face value and coupon payments) compared to the bond price. Current yield compares the cash flow (income + principal) you receive annually compared to the market price. In other words, cash flows of premium bonds are made up of a combination of yield income plus return of premium paid. Some of your own principal being returned is quoted in the current yield calculation.
Let’s simplify through an example. An SMA might quote a current yield of 2.79%. If you took the exact same bonds and calculate the yield-to-maturity, it is 1.55%.
2.79% versus 1.55% can create a very different bias towards the investment, yet it is the exact same portfolio of bonds. The choice of which yield is quoted is based on regulatory and practiced methods. Neither is right or wrong, you just need to make sure you are comparing the two appropriately.
Here’s another example. I just selected a pool of low duration corporate bonds with a yield-to-maturity of 1.46%. The Mutual Fund / SMA comparative yield is 3.98% (current yield). In other words, if the exact same bonds were represented in a mutual fund, the quoted yield would be 3.98%. The intent isn’t to confuse but requires understanding.
There are some other important differences as well as similarities to consider. Fund managers, mutual funds, closed-end funds, individual bond buyers, etc., all select bonds from the same marketplace as each other. If anyone has an “advantage”, it might be a firm that has a large underwriting department, meaning, that firm is originating new issues of a particular product.
Raymond James investors benefit from our large firm size in that the sheer volume of securities, size and number of trades, and underwriting capabilities can present opportunities for superior execution of trades and new issue access. In certain cases, Raymond James underwrites and sells the bonds that are sold in packaged funds.
Expertise and experience certainly can play a role in performance. Funds and SMAs are often managed by such an expert or group of experts. Bond desks that sell, trade and underwrite individual bonds can have tens if not hundreds of such experts. Raymond James by example, has a fixed income trading desk with well over 200 experts, experienced traders, analysts, and underwriters.
Composition of bonds is typically where differences subsist. A portfolio consisting of 23% Treasuries, 24% agencies, 33% BBB-rated corporates, 17% asset-backs, and 3% junk paper should do better than a group of bonds consisting of 73% Treasuries, 10% agencies, 10% A-rate corporates and 7% BBB-rated corporates. The first group of bonds carries more risk and therefore should provide higher yield. A benchmark comparison is likely most meaningful when the benchmark matches a relatively same composition of bonds and risk. For us, the most meaningful benchmark can be the one you tailor to create for your own personal needs/goals.
Although managed money may simplify the process, there exist certain differences to a tailored portfolio of individual bonds: 1) The portfolio can be composed of exactly what the client desires. This could range from 100% Treasuries if desired, to a high percentage in lower-rated, higher yielding bonds if desired to whatever composition an investor can dream up; 2) Individual bond portfolios can be composed and held without annual or periodic management fees eating into income; 3) Investors choose whether to hold or sell and never are forced into unwanted transactions; 4) Principal owned does not fluctuate with a net-asset-value change. Bonds are owned and controlled; 5) When held-to-maturity, individual bond income, cash flow and date that face value is returned is unaffected by interest rate movements. Only early redemption or default would change this.
Situations and choices can be very different from client to client and there is no right or wrong answers about your criteria, goals and objectives. Just approach it with eyes wide open!
*Yield-to-maturity was used in comparison to current yield for this discussion. Yield-to-worst may apply for callable bonds held at a premium. The logic applies in either case: current yield versus YTM or YTW are not necessarily good direct comparisons and investors should understand the distinctions. Please contact your advisors if you need detailed explanation or clarification.
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