2 min read.Updated: 08 Dec 2021, 06:15 AM ISTAnand Nevatia
Understanding the concept of yield to maturity
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Yield to maturity (YTM) is an important concept for debt capital markets. The YTM for a bond implies the total return from the bond when held till maturity and includes both coupon and principal payments.
There are two key concepts in realizing the exact return as the 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 till maturity, provides the return which exactly matches the YTM at the time of investment.
Fixed income investors tend to extrapolate this concept of YTM even while selecting a debt mutual fund scheme. Typically, a scheme with a higher YTM is given preference as investors wrongly equate the YTM of the scheme to the probable returns on the scheme. The YTM of the scheme is only stating total yield of the portfolio for that particular day and not for a specified period of investment. As the pricing of the underlying instrument changes daily, the YTM of the portfolio changes daily as well. Mutual fund schemes are open-ended schemes and do not have a definitive maturity date.
Dynamic in nature
The scheme portfolios are dynamic in nature i.e. the portfolio constituents keep changing basis the interest rate outlook and other factors. As a result, the YTM of the scheme also keeps changing depending on the portfolio constituents. The YTM of the debt mutual fund portfolio is a derivative of two key factors in the portfolio:
A portfolio with a low credit quality and high maturity will tend to have YTM higher than a portfolio with high credit quality and low maturity. The above chart also highlights the basics of investing; higher the YTM, higher the risk in the portfolio. The higher risk can be attributed either to the low portfolio quality or to the elevated interest rate sensitivity arising from higher maturity.
The YTM is largely indicative 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 functioning like an open-ended FMP. In a roll down strategy, the scheme invests in bonds with a predefined indicative maturity and holds on to those bonds till maturity. Additional inflows are 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 akin to investing in a bond with a specific maturity and defined YTM.
With well-defined scheme categorization, the investors are assured of the duration range as well as the broad credit profile of the scheme at all points in time. If the investor has the view that the interest rates are likely to go down, they would want to invest in schemes with longer duration. If the view is on the contrary, then they should opt for schemes with shorter duration. Investors having higher risk appetite can explore credit funds, but if the focus is more towards capital preservation, then a banking and PSU debt fund or a scheme with high credit profile is a more appropriate choice.
Investing in a debt mutual fund scheme is a fairly simple process: evaluate the portfolio credit profile, evaluate portfolio maturity and duration, and finally evaluate comparative yield to maturity to arrive at the final decision. Investors must note that YTM alone is not a sufficient criterion to make an investment decision.