Yield to maturity (YTM) is an important concept for debt capital markets. The YTM for a bond involves the total return on the bond when held to maturity and includes both coupon and principal payments.
There are two key concepts to achieving exact yield as YTM:
1. All intermediate cash flows are reinvested at the same rate.
2. The investment is held to maturity.
In the real world, only a zero coupon bond, when held to maturity, provides the return that exactly matches the YTM at the time of investment.
Fixed income investors tend to extrapolate this concept from YTM even when choosing a debt mutual fund. Generally, a plan with a higher YTM is preferred because investors mistakenly equate the plan’s YTM with the likely returns of the plan. The program YTM only shows the total portfolio return for that particular day and not for a specified investment period. As the price of the underlying instrument changes daily, the YTM of the portfolio also changes daily. Mutual funds are open-ended systems and have no final expiry date.
Dynamic in nature
Plan portfolios are dynamic in nature, meaning that the constituents of the portfolio are constantly changing based on the outlook for interest rates and other factors. As a result, the YTM of the plan also continues to evolve depending on the constituents of the portfolio. The YTM of the debt mutual fund portfolio is a derivative of two key portfolio factors:
A portfolio with low credit quality and high maturity will tend to have a higher YTM than a portfolio with high credit quality and low maturity. The chart above also highlights the basics of investing; the higher the YTM, the higher the risk in the portfolio. The higher risk can be attributed either to the low quality of the portfolio or to the high sensitivity to interest rates resulting from a higher maturity.
The YTM is broadly indicative of plan performance for closed plans such as Fixed Maturity Plans (FMP). In an open system, investors can expect to generate returns similar to YTM when the system executes a “roll down strategy”, that is, the system operates like an open-ended FMP. In a roll-down strategy, the system invests in bonds with a predefined indicative maturity and holds these bonds until maturity. The additional inflows are reinvested in bonds that match the stated initial maturity profile of the plan. Investing in an open-ended plan with a roll-down strategy amounts to investing in a bond with a specific maturity and a defined YTM.
With a well-defined categorization of plans, investors are assured of the duration range as well as the broad credit profile of the plan at all times. If the investor believes that interest rates are likely to fall, they will want to invest in longer term programs. If the opinion is not, then they should opt for shorter duration diets. Investors with a higher risk appetite can explore credit funds, but if the focus is more on capital preservation, a bank debt fund and PSU or a program with a high credit profile is a choice. more appropriate.
Investing in a debt mutual fund is a fairly straightforward process: assess the portfolio’s credit profile, assess the maturity and duration of the portfolio, and finally assess the comparative return to maturity to arrive at the final decision. Investors should note that YTM alone is not a sufficient criterion for making an investment decision.
Anand Nevatia is Fund Manager, Trust Mutual Fund.
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