How to use the SEC yield when choosing funds?

[rach]

I'm a little confused over how to interpret the SEC yield for an index fund that has a large fraction (>45%) of its shares in bonds.  I read that typically the yield will approach the SEC yield as a bond nears maturity but if this is a fund of many bonds then surely new ones are added as older ones mature?  Thus, the fund will not necessarily approach the SEC yield ever.  (Assuming consistent interest rates for the prior example).

So what's a good way to compare funds?  Is using the SEC yield better than looking at the average annual returns?  (I know, I know - past performance is not an indicator of future performance but you can get an idea of how volatile a fund is at least).  Also, the SEC yield is consistently several percentage points lower than the average annual returns.  It seems strange to assume that, despite an average of 6% returns over the last decade and 7% in the last year, the yield will suddenly drop to 2% (which is the SEC yield).  Is the SEC yield really an estimation of expected performance for these types of funds or am I misusing it?

Thanks.

[KingCoin]

The performance of bonds (especially long maturity bonds of high credit quality) is driven heavily by changes in interest rates. That accounts for the potentially large discrepancy between SEC yield and performance the previous year.

To illustrate with a hypothetical example:
On Jan 1 2011 you buy a fund of 30yr treasuries that has an average yield to maturity of 4%. Over the course of the year, treasuries become in demand and 30yr interest rates fall to 3%. On December 31 2011 your fund performance is about +24% (roughly 4% from the SEC yield and 20% from rising prices due to falling interest rates). The SEC yield on this fund is now roughly 3%.

So if you're looking at that fund, you see a 1yr performance of +24% and an SEC yield of 3%, seemingly a huge disparity. The SEC yield is a good indicator of what to expect going forward if interest rates stay roughly the same.

Over the past 5 years, bonds have experienced an epic rally. This accounts for the big time performance numbers of late. This could easily reverse itself if the economy and/or inflation start picking up steam, which is why so many investment advisors are bearish on bonds right now.

[rach]

Thanks for the great example. 

A follow-up question: the SEC yield is way below past annual yields even for funds that are entirely stocks.  e.g. the SEC yield for the Vanguard 500 index (VFINX) is 2.1%, which seems very low.  Is it just because the last 30 days have been somewhat dicey, given the fiscal cliff discussion? 

Thanks in advance for the help!

[grantmeaname]

Why do you care what the SEC yield is for a fund of stocks? Isn't it designed for bond funds?

You don't spend the SEC yield, you spend your investment returns. It's like me being concerned because my otherwise excellent investments have an Imaginary Internet Coefficient of only .2 -- who care?

[rach]

Sounds like it's irrelevant then.  I'm new to this...

[KingCoin]

The SEC yield for stocks is basically just the dividend yield. As grant mentioned, your stock returns are going to come from a combination of capital gains and dividends, so it's not a useful indicator of "expected returns".