Don’t Believe the Inflated Yields on Inflation-Protected Bond Funds

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Mutual funds and exchange-traded funds that buy TIPS, or Treasury inflation-protected securities, are boasting yields of 8% or more in a bond market where even 4% looks outlandish. Such funds took in an estimated $36.3 billion in new money in the first half of 2021, according to Morningstar—a record for any six-month period since TIPS funds were born in the late 1990s.

If an 8% yield tempts you to join them, listen up. These funds that purport to fight inflation are, ironically, inflating their own reported yields.

I’ve written about this problem before, but it’s never been worse. This week, every single inflation-protected security was trading at a negative yield to maturity before inflation. Yet more than two dozen mutual funds and ETFs that own these bonds are reporting yields of 6%, 7%, even 8% or more.

How the heck can that be? Are investors expecting double-digit rises in the cost of living? Or are fund companies exploiting a regulatory loophole for marketing purposes?

TIPS are notes and bonds, issued by the U.S. Treasury, whose value varies with changes in the monthly Consumer Price Index. When that measure of inflation rises, the principal value of each of these securities goes up; so does its interest payment. When inflation declines, the TIPS’ value and interest fall with it.

TIPS pay interest, albeit not much these days—a 5-year note sold in April has a coupon of 0.125%. A big chunk of the return instead comes from the inflation adjustment to the principal.

On websites and in other marketing, funds display what’s commonly known as SEC yield. That number is sky-high right now.

Under rules from the Securities and Exchange Commission, funds take “dividends and interest” earned per share during the prior 30 days, deduct expenses and annualize it. The resulting SEC yield tends to be roughly what you’d get if you multiplied the previous month’s net income by 10 or 12.

The SEC’s rules for calculating its yield, however, don’t say whether to include the inflation adjustment or leave it out.

And that gives fund companies a lot of leeway.

As the economy roared back, the Consumer Price Index came in at unusually high levels of 0.8% in May and 0.9% in June. Those are monthly numbers, so funds that annualize them and include the inflation adjustment to principal in their income have been reporting monster SEC yields. To believe in that yield is to imagine that such fluky numbers are sustainable.

Among the many examples this week were the $9.7 billion Fidelity Inflation-Protected Bond Index Fund (SEC yield: 7.11%), the $12.4 billion Pimco Real Return Institutional Fund (8.2%) and the $29.2 billion iShares TIPS Bond ETF (8.4%).

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“To help our clients make fully informed investment decisions,” says a Fidelity spokesman, “we [also] disclose the distribution yield for our bond funds, which is a better reflection of the shareholder experience.”

Distribution yield measures a fund’s income payouts, which also can include cost-of-living adjustments to principal.

Steve Rodosky, co-portfolio manager of Pimco’s inflation-protected bond funds, says the firm calculates and displays the yield “in accordance with the SEC rules.” Pimco’s disclosures also present distribution yield and estimated yield to maturity. As of July 14, for instance, at Pimco’s 1-5 Year U.S. TIPS Index ETF, the SEC yield was 8.79%; distribution yield, 6.89%; and the yield to maturity, 0.55%.

“From a market-expectation perspective, the estimated yield to maturity is a more stable indicator” than SEC yield, says Daniel He, another co-manager of Pimco’s TIPS funds.

In addition to SEC yield, says Karen Schenone, a fixed-income strategist for iShares, “investors should also look at yield to maturity and real yield” (or TIPS income adjusted for the inflation rate). Those measures are also displayed on iShares’ website and in other marketing materials.

Earlier this year, iShares added a pop-up disclaimer to its website: “An exceptionally high 30-day SEC yield may be attributable to a rise in the inflation rate, which might not be repeated.”

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At least $109 billion is invested in TIPS funds with SEC yields of 6% or more, according to Morningstar—roughly half the category’s total assets.

Not all have chosen to report inflated yields, though.

State Street Global Advisors is reporting negative SEC yields on several funds, including SPDR Bloomberg Barclays 1-10 Year TIPS ETF and SPDR Portfolio TIPS ETF. Vanguard Group also shows negative reported SEC yields on its TIPS funds.

“In my view, including the inflationary adjustment to the principal [in] the SEC yield is incredibly misleading,” says Matthew Bartolini, head of ETF research at State Street Global Advisors. “It assumes that, on a go-forward basis, the inflation reading in the prior months will be persistent” even though the Consumer Price Index can vary wildly from month-to-month. “And many are unaware of this.”

Right now, “the market is experiencing very high month-over-month inflation, and a calculation that annualizes inflation accretion may reflect an overstated view of expected yield,” says a Vanguard spokesman. “Our practice has been to avoid that adjustment, which results in SEC yields on Vanguard funds with TIPS exposure appearing lower than other firms. Conversely, during periods where monthly inflation is negative, our SEC yield may look higher.” The firm feels this approach represents its TIPS funds’ real yield consistently and accurately, he says.

In short, you can’t earn 8% income in a 2% bond market. And funds that claim to be protecting against inflation should protect their investors against inflated expectations, too.

Write to Jason Zweig at intelligentinvestor@wsj.com

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