Quirky ETFs

Let's begin by separating income from yield. Income is simply what the word says - it's the money that you get from pledging your capital to a venture of some sort. It may be what you make from putting a lump into a savings account, or from putting another chunk into Vodafone's shares. But the point is that income is always - and only - a sum of money.

Yield, meanwhile, expresses income as a rate of return. So it's never an amount of money, and is always the result of dividing income by an appropriate denominator. In investing, that denominator is almost always either the cost of an investment or its market value. For example, I paid 634p per share for the income fund's holding in electricity utility SSE, whose latest full-year dividend was 80p. That means the fund's income per share in 2011-12 was 80p, which produced a yield of 12.6 per cent on cost and just 5.6 per cent on market value (with SSE's share price at 1,436p).

So far, so simple. Now let's think about yield and fixed-income securities. Imagine that I put some of the income fund's capital into Centrica 7 per cent 2033. This is an 'investment grade' - ie, high quality - corporate bond issued by the gas utility. It is listed on the London Stock Exchange so the proposition is perfectly practicable. The '7 per cent' tells us that for every £100 that Centrica borrowed, it will pay £7 a year in interest.

If I had wanted to capture that £7 of income three years ago, I would have had to pay £117.80 for every £100-worth of stock and that would have generated a 5.9 per cent income yield. Today's rock-bottom interest rates mean that Centrica's promise to pay £7 a year has become more valuable. Someone wanting it now would have to pay £142.60, which means they would be satisfied with a 4.9 per cent yield. That wouldn't matter to me. I'd be sitting on a 21 per cent capital gain and would still be getting £7 of income for every £117.80 I had invested.

But, if my Centrica holding somehow morphed into an ETF, then my income would have been cut. Instead of getting £7 for every £117.80 I had invested, I would now get only £5.77. That's because the income part of my return would be dictated by the current yield on the bond, which, because of its rising price, has fallen to 4.9 per cent.

Indeed, something very much like this has happened to the income fund's holding in iShares Markit iBoxx £ Corporate Bond (code: SLXX), which is a portfolio of bonds all much like Centrica 7 per cent 2033 (in fact, the Centrica bond is one of its biggest holdings). Three years ago, this ETF distributed almost £1.91 a quarter when its market price was around £94. Now the price is £129.40 and the latest distribution is down to just below £1.22.

The reason for this quirk is that the aim of the iShares corporate bond fund, like many ETFs, is to track the total return of a financial market index. So, as the fund's price rises in line with its underlying index, the income part of the total return falls because market yields are being driven lower. And income that would be unchanged if I owned the underlying stocks is cut because it moves in line with market yields.

Granted, there is an obverse to this, which is that income rises when prices fall because the market yield also rises. Still, it does mean that the days are numbered that this iShares ETF will remain in the income fund. I bought last December, saying that "I see this as a good place to park capital while uncertainty rages". With a total return of 12.4 per cent in the 10 months since then, it has done its job. But it's time to move on.

As I have also just sold my holding in electricity generator Drax (see Bearbull 3 August 2012 for reasons why), the income fund will soon have £50,000 of cash to invest. Clearly, it's time to do some number crunching on candidates.