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Business News/ Mutual Funds / News/  High YTM in your debt mutual funds may be a red flag to watch out for

High YTM in your debt mutual funds may be a red flag to watch out for

High yield-to-maturity indicates high returns, but it also means that the fund may be taking higher risk
  • Remember that the YTM of a fund will change when securities are bought and sold in open-ended funds
  • Photo: iStockPremium
    Photo: iStock

    The recent Franklin Templeton Mutual Fund fiasco, which saw it shutting six of its debt schemes, has once again highlighted the risks funds face when fund managers take aggressive credit calls to chase higher returns.

    Five out of the six Franklin schemes that were shut were among 10 open-ended debt funds with the highest yield-to-maturity (YTM), as per the March-end portfolios, according to data from Crisil. YTM of a fund indicates how much return it is expected to deliver, assuming it holds all its debt papers till maturity. Apart from the Franklin funds, five other debt funds have a YTM above 10% as in the March-end portfolio. The two funds with the highest YTM are Aditya Birla Sun Life Medium Term at 16% and Nippon India Credit Risk Fund at 13.37%. Franklin Templeton Short Term Income fund had the third-highest YTM among all debt funds, at 13.03%, while Edelweiss Short Term fund was next with a YTM of 12.35%.

    A higher YTM indicates higher returns, but it is also associated with higher risk, as the fund may be holding risky papers offering higher yields. So should investors of debt funds with higher YTM be worried?

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    High YTM, high risk

    The YTM of a debt fund is basically the weighted average yield of the underlying debt papers of a fund in proportion to the assets invested in those papers.

    A debt security with a higher risk of default will have to compensate investors with a higher yield. The fund buying such paper trades off the higher risk for higher returns. But if the issuer defaults, the value of the holding in the fund has to be written off and the net asset value (NAV) takes a cut depending upon how much of the security it was holding. “The YTM of the fund not only indicates the returns, but also the risk of the underlying portfolio of the fund. Higher the YTM, higher the risks," said Prateek Mehta, co-founder, Scripbox, a mutual fund investment platform.

    A fund may see its YTM go up if the existing papers in its portfolio see a fall in price due to deteriorating credit quality. Since price and yield are inversely related, the fall in price on account of the higher risk will push up the yield of the bond and of the funds holding it. This explains the high YTM in the Aditya Birla Sun Life Medium Term fund, which saw a fall in the value of certain securities related to the IL&FS issue. According to A. Balasubramanian, managing director and CEO, Aditya Birla Sun Life AMC Ltd, “We have 67% of our portfolio in highly rated papers such as sovereigns and AA+ and above. The yield of the fund is high due to the conservative valuations exercised for certain securities which we have in IL&FS Special Purpose Vehicle."

    “Following a conservative approach, we marked down the value of these securities (of IL&FS) eight to nine months ago after the rating downgrade. One of the assets is standard with regular debt servicing and the valuation impact of eventual mark-up is yet to come. Other assets from the group are at the final stages of resolution," he added, referring to the possibility that an improvement in credit quality will see the value of the securities go up and have a positive impact on the NAV, and reduce the yield.

    The liquidity, or lack of it, in the secondary market can also increase or decrease the yields of debt papers. In tighter liquidity conditions or poor credit scenario, where people move towards safety and become risk-averse (a condition we are witnessing right now), the yields of lower-rated papers and the YTM of funds holding these papers generally go up as the prices of the papers fall on account of low demand.

    Secondary market liquidity for securities rated A+ and below have always been tight and this has now almost frozen with deteriorating credit situation as the impact of the economic shutdown reflects on companies’ ability to service their debt.

    How to interpret YTM

    Often YTM is used as an indicative return that the fund is expected to deliver after deducting expenses. This may be misleading as the YTM of the fund will change when securities are bought and sold in open-ended funds. More importantly, YTM does not consider the impact of capital gains and loss on the securities held in the portfolio on the returns. “An investor should always look at the YTM of a fund along with the quality of the underlying portfolio as high YTM may not necessarily mean high return," said Ashish Shanker, head, Investment Advisory at Motilal Oswal Private Wealth Management.

    The YTM of a debt fund should be used to understand how the portfolio is managed. A fund with a high YTM relative to other funds with similar duration should lead the investor to examine the portfolio closely to understand the risks. A change in YTM over a period may indicate change in credit quality, but it could also be the result of a change in market interest rates.

    “A rise in YTM will result in a loss to the existing investors while new investors can benefit if the YTM falls due to write-backs that may happen due to the rating upgrade of the underlying security," said Balasubramanian, referring to the impact on existing investors of a fall in NAV as a result of a decrease in the value of poor quality securities held and the consequent rise in YTM. But investors who buy into the fund at these levels will stand to gain if the quality of the securities improves and the price and NAV rise.

    “We didn’t want new investors to benefit at the cost of existing investors and to avoid mis-selling of the fund showing higher YTM. We have restricted lump sum investments to 10 lakh per investor," he added. Existing investors shouldn’t take the risk of taking additional exposure to these funds to benefit from a possible increase in value if the quality improves and the YTM comes down in the future. “This is not the right time to take such risky bets as the economy is going through a slowdown. Deploy fresh investments in better quality funds," said Joydeep Sen, founder,

    What you should do

    A high YTM of a fund relative to its peers may indicate higher credit risk and may be a red flag for investors uncomfortable with it.

    This is especially true for fund categories that investors use for liquidity and short-term parking needs, such as liquid, ultra-short and low duration funds. Since holding periods in such funds may be low, it will not give the investor enough time to recoup any capital erosion on account of write-downs and defaults. “Investors don’t expect credit risk in these lower duration funds," said Sen.

    For funds that are part of the core allocation, such as short-duration and corporate bond funds, investors should evaluate the portfolio quality with the help of their advisers. “It depends on the quality of the portfolio. If it is a small percentage with a high yield (low price) and the balance portfolio is decent, one can stay. If the portfolio yield is very high and quality is questionable, then take a call," said Sen.

    As for credit funds, where investors look to invest in high YTM funds to benefit from a future re-rating gains, indicators such as a deteriorating credit ratio points out to increased vulnerability in the economy and a far from suitable environment for the strategy to play out. Investors should stay away at this point in time.

    The role of fixed-income assets in a portfolio is to balance out the volatility in equity assets. Therefore, investors shouldn’t simply chase high returns, but try and understand the risk of the underlying portfolio of the debt fund before investing.

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    Published: 03 May 2020, 08:52 PM IST
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