Yield to maturity: A guide for mutual fund investors

One of the most important things to consider when investing is the return capability of the investment vehicle. For equity, there are ratios like the risk-reward ratio that help you assess the maximum risk to take for a trade.

When it comes to bonds, returns are termed as yield. The maximum yield of a bond is achieved when you hold it till the maturity period. Yield to maturity ratio is a key measurement that can help you with that. Read on to understand more about the yield to maturity ratio and how it can help when investing in bond funds.

What is yield to maturity?

Yield to maturity (YTM) measures the total return an investor can anticipate earning on a bond or other fixed-income investment if they hold it until its maturity date.

For mutual funds that invest primarily in bonds and other fixed-income securities, YTM indicates the hypothetical overall yield an investor could earn from the fund in the coming years. It assumes all the fund's holdings are held to maturity.

How does YTM help with your mutual fund investments?

As an investor, YTM helps you in two key ways. One, it allows you to compare potential returns between different bond funds. Generally, the higher a fund's YTM, the greater the potential total return. It also helps you estimate the actual income distributions you may receive from a bond fund annually. The annual percentage YTM can give you a sense of the dividend payments you might see each year.

For example, consider two bond funds, Fund A and Fund B. Fund A has a YTM of 6%, while Fund B's YTM is 4%. Given similar risk levels, Fund A likely has greater income potential in the coming years. Its 6% YTM suggests higher potential dividends than Fund B's 4% YTM.

YTM example for a mutual fund investment

Let's look at a hypothetical example to better understand YTM.

Say you are considering investing Rs. 50,000 in the ABC Bond Fund, which invests primarily in corporate bonds. The fund has a YTM of 5.5%. What does this mean?

Based on the 5.5% YTM, you could potentially earn a total return of 5.5% per year if you invest Rs. 50,000 in the fund and hold it until the bond matures. Over the fund's stated average maturity period of 8 years, this would equate to total cumulative returns of approximately Rs. 22,000 (Rs. 50,000 x 5.5% x 8 years).

In terms of annual income distributions, the 5.5% YTM suggests you might receive dividend payments around Rs. 2,750 per year on your Rs. 50,000 investment (Rs. 50,000 x 5.5%).

Of course, YTM is based on an assumption that all the fund's bonds are held to maturity. In reality, the fund manager actively trades bonds, so actual returns may differ from the YTM projection. Still, it offers a reasonable estimate of the income potential from the fund.

Other key ratios to consider

While YTM is extrememly useful for analysing potential bond fund returns, other ratios also provide valuable insights. Some additional metrics to examine include the below:

• Expense ratio - The annual fee charged by the fund, expressed as a percentage of assets. Lower is better.

• Average maturity - The weighted average time until the bonds in the fund mature. Longer maturity may mean higher YTM but greater volatility.

• Credit quality - The credit ratings of the bonds in the fund. Higher credit quality usually means lower yields but less risk.

• Yield to worst - The lowest potential yield assuming bonds get called early. More conservative than YTM.

The Bottom Line

Yield to maturity is a key metric that helps mutual fund investors like you estimate and compare potential returns on bond fund investments. By grasping how YTM works and using it along with other key ratios, you can make more informed decisions when selecting bond funds. Focusing on the fundamentals like YTM can lead to smarter mutual fund investments.