Pop quiz: Which one-year bond will offer the higher return over the next twelve months (assuming no default)?
A. Bond A: 5% current yield1
B. Bond B: 7% current yield
C. Not enough information to decide
If you answered “C” (not enough information to decide) – you are correct! Without the price of the bond, you can’t calculate the yield-to-maturity or our preferred metric, yield-to-worst (i.e., yield to the expected repayment date).
Once you include the price, the answer is straight-forward:
A. Bond A: 5% current yield; price $90
B. Bond B: 7% current yield; price $101
C. Not enough information to decide
Answer “A” is the correct answer: Despite “Bond A” having a lower current yield than “Bond B,” it will have a higher total return (assuming no default).2
Bond investors have been able to use current yield, or over the last few years in the case of bond funds, the SEC yield, as a shorthand proxy for expected total returns because the average price of investment-grade bonds had been near par ($100). But that’s not the case any longer as you can see from the chart below.
As of December 31, 2022. Source: Bloomberg. The Bloomberg U.S. Aggregate Bond Index (“Agg”) represents the U.S. universe of intermediate term (between 2-10 years to maturity) investment grade bonds that have at least one-year to maturity. The Bloomberg U.S. Aggregate 1-3 Year Bond Index is a subset of the Agg as its universe contains bonds with maturities of only 1-3 years.
Given the rapid rise in the yields across all maturities in the past year, the price of bonds is now (unsurprisingly) at decade lows. We believe this means investors need to focus more than ever on yield-to-worst rather than current yield. That’s because current yield, may overstate expected total returns when bonds trade at prices well above par (like in 2012 or late 2020) but may understate expected total returns when prices are well below par (like today).
In conclusion, depending on market conditions, we believe yield-to-worst offers the same or better insight into expected total returns than the current yield. However, when comparing bond funds or ETFs based on yield-to-worst, an investor must also consider investment objectives, fees and expenses, differences in credit quality (credit risk), and differences in duration (interest rate risk). Bonds or funds with a higher yield-to-worst may have more risk.
As of December 31, 2022. Source: Bloomberg and Morningstar.
Yield-to-Worst (“YTW”) is presented gross of fees and expenses and reflects the lowest amount that an investor could make from a bond, computed by using the lower of the yield to maturity and the yield to call on every call date and assuming no defaults. It does not represent the yield an investor in the Fund should expect to receive. Current Yield is presented net of fees and expenses and represents an investment's annual income (interest or dividends) divided by the current price of the security. As of December 31, 2022, the FPNIX subsidized/unsubsidized 30-day standardized SEC yield (“SEC Yield”) was 3.23%/3.06% respectively; FPFIX subsidized/unsubsidized 30-day standardized SEC yield (“SEC Yield”) was 3.89%/3.75% respectively. The SEC Yield calculation is an annualized measure of the respective fund’s dividend and interest payments for the last 30 days, less the respective fund expenses. Subsidized yield reflects fee waivers and/or expense reimbursements during the period. Without waivers and/or reimbursements, yields would be reduced. Unsubsidized yield does not adjust for any fee waivers and/or expense reimbursements in effect. The SEC Yield calculation is based on the price of the respective fund at the beginning of the month. The SEC Yield calculation shows investors what they would earn in yield over the course of a 12-month period if the respective fund continued earning the same rate for the rest of the year. The Vanguard Short-Term Bond ETF and iShares Core Total USD Bond Market ETF are being shown as proxies because they have comparable investment universes as FPNIX and FPFIX, respectively.
For an in-depth view of the FPA fixed-income funds' performance and characteristics, we encourage you to review each fund's fact sheet by clicking on the links below:
FPA New Income, Inc. Fact Sheet
FPA Flexible Fixed Income Fund Fact Sheet
1 Current Yield is the annual income (interest or dividends) divided by the current price of a security.
2 Higher “total return” reflects yield to worst. Both Bond A and B will receive par ($100) at maturity plus respective coupon payments, however Bond B will need to amortize $1 since its price is above par. The difference in coupon payments will not offset the price difference. Yield-to-worst reflects the lowest amount that an investor could make from a bond, computed by using the lower of the yield to maturity and the yield to call on every call date and assuming no defaults.
This communication is for informational and discussion purposes only and does not constitute, and should not be construed as, a recommendation, financial promotions, investment advice, encouragement or an offer or solicitation for the purchase or sale with respect to any securities, products, or services discussed, and neither does it provide investment advice. Any such offer or solicitation shall only be made pursuant to the relevant offering documents for a fund or account in the FPA Absolute Fixed Income or FPA Flexible Fixed Income strategies (each a “Strategy” and collectively, the “Strategies”), which supersedes the information contained herein in its entirety. This communication does not constitute an investment management agreement or offering circular. The information and data presented has been prepared from sources believed reliable, but the accuracy and completeness of the information cannot be guaranteed and is not a complete summary or statement of all available data. You should not construe the contents of this communication as legal, tax, investment or other advice or recommendations.
You should consider FPA New Income, Inc.’s and FPA Flexible Fixed Income Fund (each a “Fund”, and collectively the “Funds”) investment objectives, risks, and charges and expenses carefully before you invest. The Prospectus for each Fund details each Fund's objective and policies, charges, and other matters of interest to the prospective investor. Please read the Prospectus carefully before investing. The Prospectus may be obtained by visiting the website at www.fpa.com, by email at email@example.com, toll-free by calling 1-800-982-4372 or by contacting each Fund in writing.
Any Fund data included herein represents past performance and investors should understand that investment returns and principal values fluctuate, so that when you redeem your investment it may be worth more or less than its original cost. As with any investment, there is always the potential for gain, as well as the possibility of loss. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Current month-end performance data for each Fund, which may be lower or higher than the performance data quoted, may be obtained at www.fpa.com or by calling toll-free, 1-800-982-4372.
Abhijeet Patwardhan has been portfolio manager for FPA New Income, Inc. since November 2015 and FPA Flexible Fixed Income Fund since December 2018. Thomas Atteberry managed/co-managed the FPA New Income, Inc. from November 2004 through June 2022, and co-managed FPA Flexible Fixed Income Fund since December 2018. Effective July 1, 2022, Mr. Atteberry transitioned to a Senior Advisory role. There were no material changes to the investment process for either fund due to this transition.
The information contained herein reflects the opinions of portfolio managers as of the date provided, is subject to change without notice, and may be forward-looking and/or based on current expectations, projections, and/or information currently available. Such information may not be accurate over the long term. Actual results may differ from those anticipated. The views are those of the portfolio managers acting in their individual capacities and not as representatives of the firm. These views may differ from other portfolio managers and analysts of the firm as a whole and are not intended to be a forecast of future events, a guarantee of future results, or investment advice. The portfolio managers and/or FPA cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Future events or results may vary significantly from those expressed and are subject to change at any time in response to changing circumstances and industry developments.
Investments, including investments in mutual funds, carry risks and investors may lose principal value. Capital markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The Strategies/Funds may purchase foreign securities, which are subject to interest rate, currency exchange rate, economic and political risks. The securities of smaller, less well-known companies can be more volatile than those of larger companies.
The return of principal in a bond fund or account is not guaranteed. Bond funds or accounts have the same issuer, interest rate, inflation, and credit risks that are associated with underlying bonds owned by the fund. Lower-rated bonds, convertible securities, and other types of debt obligations involve greater risks than higher-rated bonds.
Interest rate risk is when interest rates go up, the value of fixed income securities, such as bonds, typically go down and investors may lose principal value. Credit risk is the risk of loss of principal due to the issuer’s failure to repay a loan. Generally, the lower the quality rating of a security, the greater the risk that the issuer will fail to pay interest fully and return the principal in a timely manner. If an issuer defaults the security may lose some or all of its value. Convertible securities are generally not investment grade and are subject to greater credit risk than higher-rated investments. High-yield securities can be volatile and subject to much higher instances of default. High yield securities, senior loans, private placements, or restricted securities may carry liquidity risks.
Mortgage-related and other asset-backed securities represent interests in “pools” of mortgages or other assets such as consumer loans or receivables held in trust and often involve risks that are different from or possibly more acute than risks associated with other types of debt instruments. Mortgage-related and asset-backed securities are subject to prepayment risk and can be highly sensitive to changes in interest rates. Mortgage-backed and asset-backed securities, and in particular those not backed by a government guarantee, are subject to credit risk/risk of default on the underlying mortgages or other assets. Asset-backed securities are also subject to additional risks associated with the nature of the assets and the servicing of those assets.
Collateralized debt obligations (“CDOs”), which include collateralized loan obligations (“CLOs”), collateralized bond obligations (“CBOs”), and other similarly structured securities, carry additional risks in addition to interest rate risk and default risk. This includes but is not limited to: (i) distributions from the underlying collateral may not be adequate to make interest or other payments; (ii) the quality of the collateral may decline in value or default; and (iii) the complex structure of the security may not be fully understood at the time of investment and may produce disputes with the issuer or unexpected investment results. Investments in CDOs are also more difficult to value than other investments.
The rating agencies that provide ratings are Standard and Poor’s, Moody’s, and Fitch. Credit ratings range from AAA (highest) to D (lowest). Bonds rated BBB or above are considered investment grade. Credit ratings BB and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Bonds with credit ratings of CCC or below have high default risk.
Value style investing presents the risk that the holdings or securities may never reach their full market value because the market fails to recognize what the portfolio management team considers the true business value or because the portfolio management team has misjudged those values. In addition, value style investing may fall out of favor and underperform growth or other styles of investing during given periods.
Portfolio composition will change due to active management. References to individual securities or sectors are for informational purposes only and should not be construed as recommendations by the Strategies/Funds, FPA, the portfolio managers, or the distributor (as applicable). The portfolio holdings as of the most recent quarter-end may be obtained at www.fpa.com.
Please refer to the relevant Fund’s Prospectus for a complete overview of the primary risks associated with each Fund.
Glossary of Terms
Current Yield is calculated by taking the annual coupon payment of a bond and dividing it by the bond market price.
SEC Yield The SEC Yield calculation is an annualized measure of the respective fund’s dividend and interest payments for the last 30 days, less the respective fund expenses. Subsidized yield reflects fee waivers and/or expense reimbursements during the period. Without waivers and/or reimbursements, yields would be reduced. Unsubsidized yield does not adjust for any fee waivers and/or expense reimbursements in effect. The SEC Yield calculation is based on the price of the respective fund at the beginning of the month. The SEC Yield calculation shows investors what they would earn in yield over the course of a 12-month period if the respective fund continued earning the same rate for the rest of the year.
Yield-to-Worst is presented gross of fees and reflects the lowest possible yield on a callable bond without the issuer defaulting. It does not represent the yield an investor should expect to receive.
Comparison to any index is for illustrative purposes only and should not be relied upon as a fully accurate measure of comparison. The Strategies/Funds will be less diversified than the indices noted herein and may hold non-index securities or securities that are not comparable to those contained in an index. Indices will hold positions that are not within each Strategy’s/ Fund’s investment strategy. Indices are unmanaged, and do not reflect any commissions, fees, or expenses which would be incurred by an investor purchasing the underlying securities. The Strategies/Funds do not include outperformance of any index or benchmark in its investment objectives. Investors cannot invest directly in an index.
Bloomberg U.S. Aggregate Bond Index measures the performance of the U.S. investment-grade bonds market, which includes investment-grade U.S. Government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities that are publicly offered for sale in the United States. The securities in the Index must have at least 1-year remaining in maturity. In addition, the securities must be denominated in U.S. dollars and must be fixed-rate, nonconvertible, and taxable.
Bloomberg U.S. Aggregate 1-3 Year Bond Index is a component of the Bloomberg U.S. Aggregate Bond Index consisting of securities with a remaining maturity of 1 to 3 years.
Bloomberg U.S. 1-5 year Government/Credit Float-Adjusted Bond Index is a float-adjusted version of the U.S. 1-5 year Government/Credit Index, which tracks the market for investment grade, US dollar-denominated, fixed-rate treasuries, government-related and corporate securities.
Bloomberg U.S. Universal Bond Index represents the union of the following Bloomberg indices: U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index, and the non-ERISA portion of the CMBS Index. Municipal debt, private placements, and non-dollar-denominated issues are excluded from the Universal Index. The only constituent of the index that includes floating-rate debt is the Emerging Markets Index.
iShares Core Total USD Bond Market ETF seeks to track the investment results of an index composed of U.S. dollar-denominated bonds that are rated either investment grade or high-yield. The benchmark index is the Bloomberg U.S. Universal Index.
Vanguard Short-Term Bond ETF seeks to track the performance of a market-weighted bond index with a short-term dollar-weighted average maturity. The index is Bloomberg U.S.1–5 Year Government/Credit Float Adjusted Index.
The FPA Funds are distributed by UMB Distribution Services, LLC. 235 W. Galena Street, Milwaukee, WI 53212. UMB and FINRA are not affiliated.