Yield to Maturity - Definition and how to calculate YTM

Liquidity, transparency, and market-linked returns have made debt mutual funds an excellent alternative to bank deposits. These funds invest your money in securities such as bonds, treasury bills, commercial papers, and more to generate stable returns for the investors.But with so many debt funds to choose from, how will you pick the best? Also, unlike bank deposits, debt funds don’t even declare the guaranteed returns you can earn from your investment, making the selection all the more complicated.However, certain indicators make the evaluation process easier. Yield to maturity or YTM is one such indicator you can add to your arsenal for improved decision-making if you plan to invest in debt funds.What is YTM? How is it calculated in mutual funds ? Here’s everything you should know about YTM-

YTM is a term that is generally associated with bonds. It is the annual returns an investor can earn by holding the bond until maturity. It is calculated by assuming that the investor will hold the bond until maturity, and the coupon or interest payments will be received on time before being reinvested into the bond at a rate similar to the current yield.It is worth noting that YTM is used for calculating the expected returns of a single bond. However, debt funds generally invest in multiple such securities.So, the YTM or portfolio yield of a debt mutual fund is the weighted yield average of all the bonds the scheme has invested in. It denotes the expected rate of return if the investment is held in the scheme till maturity.

Yield to maturity is calculated with the help of this formula- YTM = [ Annual Interest + { (Par Value - Market Price) / Number of Years to Maturity } ] ÷ [ (Par Value + Market Price) / 2 ] For instance, let us assume that the face value or par value of a bond is Rs. 1,000 and its current market price is Rs. 800. If the annual interest is 8% or Rs. 80 and maturity duration is 5 years. Here’s how we can calculate the YTM with the help of this formula- YTM = [80 + { (1000-800) / 5 } ] ÷ [ (1000+800) / 2 ] YTM = 13.33%

The biggest reason the YTM and actual returns of a debt fund don’t match is the inflows and outflows in the portfolio, also known as portfolio churn.For instance, let us assume that a debt scheme has an AUM (Assets Under Management) of Rs. 100 crores and YTM of 7.58% in the first month.In the following month, there was an inflow of Rs. 10 crores that will be invested at the current yield of 7.69%, which will take the YTM of the scheme to 7.59%. In the 3rdmonth, there was again an inflow of Rs. 50 crores when the yield was 7.45%. So, the updated YTM of the scheme will be 7.55%.As can be seen in the example above, the inflows and outflows in the portfolio at different yield levels impact the scheme’s YTM.Due to this, the actual returns and YTMs generally don't match in open-ended schemes. However, the two can match in the case of close-ended funds, where the inflows and outflows are fixed until maturity.

Apart from the inflows and outflows, several other reasons affect the YTM and the returns generated by a debt fund.For instance, changes in the interest rate directly impact the market value of the bond price. If the market value changes, the YTM calculation will have to include the updated price.Another critical reason is rating changes. In case the rating of a debt fund’s portfolio is downgraded, the mutual fund might take a haircut for the bonds affected by the downgrade.For instance, if a bond’s market value is Rs. 1,000 and the fund takes a haircut of 20%, the updated bond value will be Rs. 800. In order to calculate YTM, the updated market value of the bond will be taken into consideration.

As mentioned above, yield to maturity estimates what a debt fund could deliver if the investment is held until maturity. Investors can determine the required yield and then compare it with the YTM of available options to choose debt schemes that meet their expectations.But note that YTM can fluctuate throughout the investment tenure, and the returns are not guaranteed. The actual returns can be lower or even higher than the YTM.There are plenty of debt schemes with double-digit YTMs with low-rated bonds in their portfolios. The coupon rates for such bonds are generally higher. However, such schemes can be very risky and not ideal for risk-averse investors.So, while YTM can be part of your analysis process, ensure that you also consider the other important factors such as-

• Interest rate scenario
• Returns consistency
• Expense ratio, fund manager, and AUM
• Investor’s risk profile

Now that you know what YTM is and how it is calculated, you can make it a part of your investment strategy for informed decision-making. But as YTM alone offers an incomplete picture, ensure that you include the factors mentioned above in the evaluation process.In case of any queries, you can consult a professional investment advisor who can help you select suitable investments based on your risk profile and financial objectives.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.