I’ve been noticing a potentially dangerous trend of late. With razor-thin money market yields, mutual fund sponsors are slicing fees to avoid losses. The result is a miniscule net yield. Consequently, many advisors are turning to higher-yielding mortgage and short-term bond funds as a short-term savings alternative.
This may be OK if both advisors and clients are well informed of the past and potential future risks. Otherwise, disappointed clients could spell trouble for advisors and their dealers. Here are some things you should be mindful of:
> Misreading Yields. Some advisors have been looking to short-term bond funds as a result of focusing on the wrong yield indicator. Some might be influenced by recent past returns. The three largest short-term bond funds, which account for almost half of this category’s assets, boast a one-year return of 5.6% through Aug. 31. This is a solid number that instils comfort during what has been a tumultuous year.
I believe most advisors look beyond past returns but, in my experience, many will look at recent distribution rates to get a sense of the “running” yield. Doing so with the three biggest short-term bond funds would indicate a “net yield” of 2.8%, which accounted for half of the last year’s total return. Financial statements for each of these funds, however, show that virtually every one of their bonds trades above par value. By definition, then, the more relevant yield-to-maturity will be lower in the future.
If we look at short-term bonds more generally, the current yield is about 4.4% — almost exactly what you get if you add their average fees of 1.4% to their 2.8% average net distribution rate. But Canadian short-term bonds have a yield to maturity of just 2.3% (before fees) and a duration of 2.8 years. If we deduct the typical 1.4% fee for a short-term bond fund, we get a net yield of just 0.9% annually. A bond portfolio with a 2.8 year duration that yields 0.9% a year could bleed red over the course of a year if rates rise by as little as 40 basis points.
> The Risk/Return Assessment. Getting back to clients who want to stash their cash away in something that is safe and liquid, money market yields are a lean annualized 10 bps-30 bps. High-interest savings accounts generally offer 50 bps-75 bps in annual interest. Sure, it’s less than a net yield to maturity of 90 bps; but reaching for yield, in this case, comes with the very real potential of losing money.
Examining monthly returns over almost 30 years, Canadian short-term bonds have lost money in about 3% of rolling years. In order to have avoided losses in the past, a minimum holding period of 17 months was required. The largest decline was less than 7%, which occurred during the awful bond market of 1994. But this left investors underwater for more than a year. Don’t assume similar losses can’t happen if buying at current levels.
Clearly, I’m not warning about massive potential losses; these are of the single-digit variety. But for a client for whom safety and liquidity are paramount, any loss is significant. And if Canada’s asset-backed commercial paper crisis taught us anything, it’s that we should not ignore the very material risks incurred by reaching for extra yield. IE
Dan Hallett is president of Dan Hallett & Associates Inc., which provides a mutual fund recommended list and investment research to financial advisors across Canada.