Fund factsheets help - income details

Yields

Before looking at each type of yield in detail it is important to make a few points that apply to all yield figures.

Yields are not the same as interest rates. If, for example, a bank pays 2% interest, you will receive 2% a year until the interest rate changes (or the bank fails).

Yields, by contrast, offer an indication of what you might receive, but they are not guaranteed. There are two reasons for this:

First, yields are based on the income paid over the last year (for equity funds) or a snapshot of the bonds held at any one time (for bond funds). Over time the fund manager will change the underlying holdings to try and maximise returns and so the income paid will vary too. The fund manager will be keen to improve the level of income each year or at least maintain it, but there are no guarantees that this will be achieved.

Secondly, there is no guarantee that companies will pay the same level of dividends to their shareholders year-on-year. Hopefully they will pay more, but they could pay less or even none at all. Similarly a company could default on an income payment for a corporate bond.

It is also important to note how the Annual Management Charge (AMC) is paid. Charges can either be made against the capital growth of a fund (capital) or the income received (income). Where charges are made to capital it means the fund can pay a higher level of income, but it reduces capital growth potential.

Finally, please remember that capital values of stock market investments, as well as yields, can fall as well as rise and therefore you could get back less than you invest.

There are number of ways that yields are calculated; the method used will differ depending on whether the fund invests in shares or bonds and its distribution policy.

Historic Yield

The Historic Yield is calculated by looking at the income the fund has paid over the last year and dividing it by the current price.

For example:

Income paid by each unit over the last year: 4.2p
Current price of each unit 100p

Historic Yield = 4.2 ÷ 100 = 0.042 or 4.2%

Distribution Yield

The Distribution Yield is an estimate of the income that may be expected to be paid over the next twelve months divided by the current unit price. Funds can make distributions in one of two ways:

(i) The coupon method:

If the fund makes distributions using the coupon method it will simply pay out the interest it receives from the underlying holdings. Any future capital gain or loss on the price of the bonds held by the fund is not factored into the yield calculation.

(ii) The effective method:

In addition to paying out the interest it receives from the bonds in its portfolio, a fund that distributes using the effective method will also take into account any future capital gain or loss on the underlying bonds before making payments to investors.

For example:

A fund buys a bond for 96p that is due to redeem at 100p in a year's time. In that time the bond will also pay interest of 5p. Over the next year the fund will therefore receive a total return of 9p for every 96p invested: 5p interest and 4p capital growth.

Calculating the yield using the coupon method:

Income paid over the next year: 5p
Current price of each unit 96p

Distribution Yield = 5 ÷ 96 = 0.052 or 5.2%.

Calculating the yield using the effective method:

Income paid and capital growth over the next: 5p + 4p = 9p
Current price of each unit 96p

Distribution Yield = 9 ÷ 96 = 0.094 or 9.4%

Please note, these are examples only; they consider one bond in isolation. In practice, a fund will hold a mixture of bonds, many of which will not be held to their redemption date, and some of which might default. There are therefore many different factors which, taken together, will ultimately determine an investor's net income.

If the fund's AMC is taken from income, its effect will be included in the distribution yield, but not if the AMC is taken from capital. To see the effect of the AMC in these cases, it is necessary to look at the Underlying Yield.

Underlying Yield (funds investing in bonds:)

The Underlying Yield is calculated in much the same way as the effective method for the distribution yield. It therefore includes the effect of any future capital gain or loss, assuming bonds are held to redemption. Unlike the Distribution Yield, it will always include the effect of the fund's AMC, regardless of whether those charges are taken from income or capital.

Therefore, if a fund makes distributions on an effective basis and its AMC is taken from income then the Underlying Yield will always be the same as the Distribution Yield.

You might also see two other yields quoted – these were frequently used before the Investment Management Association (IMA) issued new guidelines for calculating yield figures for funds in 2007.

1. Running Yield (funds investing in bonds):
This figure is calculated by looking at the income that may be expected to be paid over the next twelve months by the bonds held, and dividing this by the current unit price. It will include the effect of the fund's AMC only if the charge is taken from income. It is therefore exactly the same as the Distribution Yield calculated using the coupon method (see above).

2. Gross Redemption Yield (funds investing in bonds):
The Gross Redemption Yield is calculated in almost exactly the same way as the Underlying Yield (see above). It therefore takes account of any future capital gain or loss, assuming the bonds in the portfolio are held to redemption, and always includes the effect of the fund's AMC whether it is made against income or capital.

The principal difference between the Gross Redemption Yield and the Underlying Yield is that whereas the Underlying Yield calculates the future capital gain or loss using the purchase price of each bond, the Gross Redemption Yield uses the current market price.

Income paid

This highlights the frequency of the dividend payment. Dividends are typically paid either monthly, quarterly, bi- annually or annually.

Type of payment

Funds with 60% or more of their portfolio invested in fixed interest investments such as corporate bonds or gilts pay ‘interest'. Within ISAs and SIPPs a 20% tax credit can be reclaimed on these interest payments. All other funds pay ‘dividends' on which the tax cannot be reclaimed however for funds held in ISAs and SIPPs there is no further tax to pay, even for higher rate taxpayers.