Understanding the concept of yield to maturity

There are two key concepts in getting accurate returns in the form of YTM:

1. All interim cash flows are reinvested at the same rate.

2. The investment is held till maturity.

In the real world, only a zero-coupon bond, when held until maturity, provides a return that exactly matches the YTM at the time of investment.

Fixed income investors also extend this concept of YTM while opting for a debt mutual fund scheme. Generally, a scheme with higher YTM is preferred as investors wrongly equate the scheme’s YTM with the potential return on the scheme. The YTM of the scheme is stating the total yield of the portfolio only for that particular day and not for the specified period of investment. As the underlying instrument’s pricing changes daily, so does the portfolio’s YTM. Mutual fund schemes are open-ended schemes and do not have a fixed maturity date.

dynamic in nature

Scheme portfolios are dynamic in nature i.e. the portfolio components keep on changing depending on the interest rate outlook and other factors. Consequently, the YTM of the scheme also varies depending on the portfolio components. The YTM of a debt mutual fund portfolio is the derivative of two key factors in the portfolio:

A portfolio with lower credit quality and higher maturity will have higher YTM than a portfolio with higher credit quality and lower maturity. The above chart also throws light on the basics of investing; The higher the YTM, the higher the risk in the portfolio. The high risk can be attributed to either low portfolio quality or high interest rate sensitivity resulting from high maturities.

YTM is broadly an indication of the return on the scheme for close-ended schemes like Fixed Maturity Plans (FMPs). In an open-ended scheme, investors can expect to generate returns similar to YTM when the scheme is running a “roll down strategy”, i.e. the scheme is acting like an open-ended FMP. In a roll down strategy, the scheme invests in bonds with a predetermined notional maturity and holds those bonds till maturity. The excess inflow is reinvested in bonds that match the initial indicated maturity profile of the scheme. Investing in an open-ended scheme with a roll-down strategy is similar to investing in a bond with a specific maturity and a defined YTM.

With well-defined scheme classification, investors are assured of the comprehensive credit profile of the scheme along with the tenure limit at all points. If the investor believes that interest rates are likely to fall, they may want to invest in long-term schemes. If the idea is to the contrary, they should opt for schemes with shorter duration. Investors who are more risk-averse can explore credit funds, but if the focus is more on capital conservation, then banking and PSU debt funds or a scheme with a higher credit profile is a more suitable option.

Investing in debt mutual fund schemes is a fairly simple process: Evaluate the portfolio credit profile, evaluate the maturity and tenor of the portfolio, and finally evaluate the relative returns to maturity to arrive at a final decision. Investors should note that YTM alone is not a sufficient criterion for making investment decisions.

Anand is the Fund Manager of Nevatia Trust Mutual Fund.