All Yields Are Not Created Equal (who knew?)

By Brad Thomason, CPA

 

When you start your career as an auditor, it becomes difficult later in life to turn it off.  Don’t believe me?  Just ask my wife how annoying it is to watch CSI or Law and Order with a former auditor.  The forensics lab or the prosecution gets even a hair out of place, and I’m on it like a duck on a junebug!

The auditor mindset embodies the notion that things need to match up.  Contradictions are attention getters, at best.  And ambiguities are just about as bad.  Auditors are happy when things are, upon examination, just as they appear to be.  Why?  Because auditors, perhaps above all others, are immersed in the proposition that information is the basis upon which people often make decisions.  Furthermore, this preoccupation with the link between information and decision makes them (us…) acutely aware of how badly things can go awry when a decision is based on information that is inaccurate or misleading.

It is for this reason that my attention was drawn to an article on the Morningstar website last week.  I was just trying to find a list of sector ETFs for a project completely unrelated to the writing of this blog.  But when I saw the article, I knew I had my next topic.

Morningstar has decided to start highlighting, on its summary stats for income funds, the yield calculation stipulated by the SEC.

If the thought that raced through your mind upon reading that was something along the lines of “I thought they already did that/If that’s a new development, then what exactly have they been reporting?” you’re not alone.

The article points out that the term “yield” actually doesn’t have a single definition.  Which is true.  It goes on to explain a couple of different approaches to getting at yield.  I can tell you that the differences ultimately boil down to some of the broader differences between cash-basis and accrual-basis accounting.  But I’m not going to try to take it any further; just Google the article if you want the nitty gritty (published 3/21/2013; “Highlighting Income: SEC Yield” by Jacobson and Herbst).

More to the point, the article also illustrates the difference between methods for several popular income funds.  For instance, the PIMCO Total Return Institutional Fund (PTTRX) has a nominal yield of 3.96%, but an SEC yield of 1.37%; that’s a difference of 2.59%.  The difference for the Templeton Global Bond A Fund (TPINX), according to the article is even larger:  3.63% (5.54% nominal vs 1.91% SEC).

It would be acceptable at this point for you to utter in an astonished voice, “How could that be?”

Again, it has to do with whether you are calculating yield based on earnings, valuation changes and the amortization of premiums paid on acquisition (the SEC method), or just dividing cash received by dollars invested.

But back to my former-auditor perspective: I’m just concerned that no one is thinking about this when they look at tables of bond yields.  I do not like the practice of “chasing returns,” but I’ve been in this realm long enough to know that like it or not, it is a common practice.  How many times is someone looking on Morningstar (or Yahoo, or wherever), seeing yield = 5.54%, and concluding it means that the fund is yielding 5.54%?  Or perhaps more pointedly, why would someone NOT draw that conclusion?  Do they realize that what they are going to actually get if they make the investment is much lower (i.e. the SEC number)?

It is the user’s obligation to know what they are looking at before they use information to make a decision.  As a principle, I believe that 100%; if for no other reason than it couldn’t work any other way in a system where individuals are free to make their own choices.

But…suppliers of information also bear some responsibility for trying to make sure that users of information can get to the bottom of where a number came from if they choose to dig that deeply.  Morningstar is doing just that in writing such an article.  I appreciate the fact that they are mentioning it now, though I have to say I’m a little stunned that this is only happening just now (I’m not a buyer of income funds, so I’ve never had grounds to look into the details).  The differences between the yield methods are not based on some new understanding of accounting for investment income: it’s all foundational stuff that hasn’t changed in generations.  So I think surprise is a pretty reasonable response to this “revelation.”  Beyond that, it makes me wonder which of their other statistics contain such significant ambiguities.

Any way you look at it though, former auditor or not, this is just another cautionary tale about knowing what’s in the numbers before you use them for decisions.  As I have written elsewhere, even if the numbers don’t lie, that’s not a guarantee that we always understand what they are telling us.  This is a pretty good example of that problem.

 

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