When it comes to fixed income funds, there is a very simple way of
estimating your future return: look at the average market yield of the individual
bonds that constitute the portfolio, net of management expenses (MER). By market yield, we mean the average interest rate
of all the bonds that constitute a funds portfolio. For example, if you know that your fund invests in a basket of bonds with an
average market yield of 6%, and if you also know that your fund's MER is 1%
p.a., you could forecast with a fair degree of certainty that this fund's average
return for the intermediate term will be in the vicinity of 5%.
It is as simple as that, and there is no need for you to waste too
much time analyzing historical performance data. Of course, most fund companies will
tell you that this is an oversimplification, and that your portfolio manager will add
value by playing the yield curve. In theory,
this is true. But in practice, it seems to be
rarely the case. Fund managers know that playing the
yield curve is a dangerous game. They also know that there is a scarce supply of
investment grade corporate and government bonds in the market. So they tend to
keep stable portfolios. This is why there is a very limited potential for
value-added from active portfolio management. For most fixed income funds, the most
important factor that determines future returns is the portfolio market yield, less MER
(referred to as "Net Yield").
How do you obtain each fund's average portfolio yield and
duration? The best source, as usual, is the fund company itself. Make sure, however, to obtain the portfolio's
market yield and not the nominal yield. There
is an important difference between the two: the nominal yield represents the original
coupon rate of the underlying bonds and is completely irrelevant for your purposes. The market yield reflects the actual interest that
you will be collecting, as determined by the market price you pay for the bond.
There is also an acceptable alternative for estimating a
fund's average market yield (net of expenses), which is to use its interest income
distribution of the most recent year as a proxy. For
example, if a fund distributed income at a certain percentage of its value, say 1% last
quarter, you can infer that its average portfolio yield was about 4% per annum. Of course, the yield may since have changed by
quarter or half per cent, but that would have applied to all other funds in the category. Do not be fooled by historical performance data, or promisses of spectacular returns: they simply don't matter.
A note of caution:keep in mind that the aforementioned technique for projecting future returns assumes that
all bonds will be paid at maturity by their issuers.
This is a fairly safe assumption to make when your fund invests in investment grade
bonds, such as those issued by federal and provincial governments, or by top class
corporations. Most Canadian bond and mortgage
funds fall under this category. However, when it comes to high yield bonds (more commonly known as junk bonds), the rules of the
game become totally different, because you would have to take default risk into account.