Apologies for this trending into misc.invest.mutual-funds territory...
For the past several months, the SEC yield of Vanguard's Short-Term Investment Grade bond fund has been at around 1.89%. But for those same months the actual distribution yield (counting ONLY income dividends, not LTCG or STCG distributions) has been sitting at around 3%.
The SEC yield computation method Vanguard has chosen for this fund is: "based on holdings' yield-to-maturity for last 30 days."
So why has this been so much lower than the distribution yield for months? I understand the difference between YTM and yield. But it's not like the NAV has been dropping. From 12/31/10 to 2/28/11 the NAV has been between $10.76 and $10.80 on distribution.
Without looking more closely than I care to, I cannot say for certain what Vanguard is doing, but I think I can offer a theoretical way this can happen (i.e. a relatively constant NAV, premium bonds [SEC yield lower than current yield] and constant SEC yield).
M* reports the average weighted price of a bond (12/31) as 104.29, and an average weighted maturity of 3.00 years. We'll simplify by using a single bond, rather than a portfolio (which could, of course, be comprised simply of N identical bonds anyway). Using a bond calculator, we see that a coupon rate of 3.37%, with a current price of 104.29, and a 3 year maturity, gives us an effective YTM of 1.88% (about the SEC yield of 1.89%).
Suppose we have a yield curve (YTM) that offers:
2 years: 1.19%
3 years: 1.89%
These yields are rigged so that the bond premium doesn't change (a 2 year bond with a coupon of 3.37% and a YTM of 1.19% will be priced at
104.29 also). I'm assuming here no shift in yield curve - the bond is simply maturing naturally. After a year passes, Vanguard, interested in maintaining an average 3 year maturity, swaps the 2 year bond for a 3 year bond. Same price (since the bond premium didn't change), same coupon, same credit quality, and we're back to a 3 year bond.
In essence, I'm freezing time - the portfolio is a perpetual three year bond, so the premium doesn't change, thus the NAV doesn't drop. I have the feeling I'm cheating somewhere here, because it suggests we should all keep swapping bonds as they age, and capture a higher yield than the YTM. In this case, we hold the bond for a year, get 3.37%/1.0429 3.23%, and then do an even swap for our "original" 3 year bond. Maybe this says that I've built a yield curve that's too steep?
Thanks for the explanation. Modulo the yield curve structure that certainly sounds plausible.
But isn't that what bond mutual funds in fact do? Especially ones chartered to target a particular duration? If nothing else they're forced to do some version of that or else they'll cease to exist as all their holdings eventually mature :).
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