YTM, and everything it assumes

What it means

For a single bond, yield to maturity is the annual return you would earn by buying it at today's price and holding it until it matures, receiving every payment on schedule.

For a fund, it is the weighted average of the YTMs of everything it holds — a summary of what the current portfolio is positioned to earn.

It is genuinely informative. It is the closest thing a debt fund has to a forward-looking number, and comparing YTMs across funds of similar duration tells you something real. The trouble is what people take it to mean.

The three assumptions

YTM is arithmetic, and like all arithmetic it is only as good as its inputs. Three conditions are baked in.

Every borrower pays in full and on time. YTM makes no allowance for default. A portfolio yielding 9% because it holds weak paper shows 9% right up until a holding is written down — at which point the realised return is nothing like it. This is the largest gap between YTM and reality, and it is invisible in the number.

Nothing is bought or sold. The portfolio is assumed held to maturity, but an open-ended fund trades continuously — reinvesting maturities, meeting redemptions, responding to flows. Today's YTM describes a portfolio that will not exist in six months.

Coupons are reinvested at the same yield. They will not be, because rates move. If rates fall, reinvestment happens at lower yields and the realised return comes in below YTM even with no defaults at all.

Which is why YTM behaves as a ceiling under favourable conditions rather than an expectation.

Subtract the expense ratio

The first correction, and the easiest.

YTM is generally quoted gross of the expense ratio. Since the expense ratio is deducted before NAV is published, the figure available to you is lower.

YTM minus expense ratio is the honest starting point — and in debt funds, where yields are modest, the expense ratio consumes a meaningful share of it. A fund with a 0.3% higher YTM and a 0.5% higher expense ratio is the worse proposition, and comparing YTMs alone gets that backwards.

This is why cost matters proportionately more in debt funds than in equity funds. The same fee is a much larger fraction of the expected return.

A high YTM is a statement about credit

The most useful way to read the number.

Two funds in the same category with the same duration will have similar YTMs if they hold similar credit quality — because yield in the bond market is largely a function of how risky the borrower is. So when one fund's YTM is noticeably higher than its peers, the difference is almost always credit, not skill.

The fund is being paid more because it is lending to weaker borrowers, or lending for longer, or both. Neither is illegitimate; both are risks the higher yield is compensating for.

The check is two lines in the factsheet: the rating breakdown and modified duration. Between them they explain nearly all of a YTM difference, and if they do not, that itself is worth a question.

The version of this that costs people money is a fund sold on its yield alone — see credit risk funds, where the premium is real and so is what it compensates for.

Using it properly

1. Compare YTM only across similar duration. A longer fund yields more for reasons unrelated to credit, so cross-duration comparison is meaningless.
2. Always net off the expense ratio.
3. Read it alongside the rating breakdown. The two together are informative; either alone is not.
4. Treat it as a ceiling. Realised return will generally be at or below it, and the gap is defaults, reinvestment and turnover.
5. Do not use it to compare against a deposit rate. A deposit rate is contractual; a YTM is conditional. They are different kinds of number, exactly as set out in debt funds versus fixed deposits.

Point five matters because the comparison is made constantly. A 7.5% YTM and a 7.5% deposit rate are not equivalent propositions, and presenting them side by side implies a certainty the fund does not offer.

YTM and your holding period

One genuinely useful application, and it links the two risks together.

If you hold a debt fund for roughly its duration, the price effects of rate moves substantially wash out and your outcome converges towards the yield you started with — the point made in matching duration to horizon.

So YTM net of expenses is a reasonable expectation for an investor whose horizon roughly matches the fund's duration, assuming no defaults. For an investor holding much shorter, it is not — their outcome depends far more on what rates did in the meantime.

That is the honest scope of the number: informative when your horizon matches the fund's, and much less so otherwise.

Checking what it actually delivered

The test of a YTM is what the fund went on to return, and that is history rather than projection.

FNOTrader's Mutual Funds app carries the full AMFI NAV history — around 34 million NAV rows — with rolling returns across every start date and maximum drawdown. Comparing realised returns over holding periods matching the fund's duration against the YTM it was advertising is the honest audit — and where there is a persistent gap, the explanation is usually costs, turnover or a credit event.

Common questions

Continue reading

More in Mutual Funds · App: Mutual Funds · Definitions: glossary · Free tools: calculators · All: every article