Article By Colin Attard
As a fixed-income metric, yield to maturity (YTM) is one of the most referenced indicators of a bond’s attractiveness and is often central in a discussion with investors when discussing portfolio selection and performance. It gives investors a standardized, annualized rate of return that matches the present value of a bond’s future cash flows — coupon payments and principal repayment — to its current market price. Although YTM provides a useful summary of a bond’s anticipated return considering certain assumptions, its meaning is often misrepresented and oversimplified. In addition, when investors move from examining a single bond to assessing the performance of a portfolio of securities, using YTM as a proxy for realized return can be misleading.
YTM assumes the bond is held to maturity, all coupon payments are reinvested at the rate equivalent to the YTM, the issuer does not default, all promised cash flows are delivered on schedule, and the investor incurs no transaction costs associated with purchasing or disposing the bond. In reality, reinvestment rates change with changes in interest rates and investors may rebalance or liquidate positions before a maturity date. Therefore, whereas YTM is an accurate internal rate of return of investing in a bond, such assumptions are often not satisfied in their entirety, leading to differences between YTM as an initial measure of return and the return actually realised.
The fact that a bond is normally held within a portfolio adds a number of different layers of complexity that further sever the direct connection between the YTMs of each instrument’s securities and the portfolio’s actual return. There are a few reasons for this divergence.
Bond portfolios create recurring cash flows from coupons and maturing securities. If coupons are not re-invested when they are received, the return will be less than the YTM. In addition, the return will deviate from the YTM if the coupons are not reinvested at the YTM prevailing when a bond was bought. More likely than not, given the evolution of interest rates during the life of the bond, coupons are reinvested at a rate higher or lower than the yield on a bond when initially bought. If coupons are reinvested in a declining interest rate environment, the return will be below the YTM. Therefore, interest rate changes impact the actual returns in a manner that YTM cannot predict. Something to keep in mind is that reinvestment income constitutes a larger portion of returns for longer-dated and higher coupon bonds.
The price of a bond fluctuates with developments primarily in interest rates, credit risk and market liquidity. A portfolio’s performance depends on any mark-to-market gains and losses realised on sales. YTM does not account for price oscillations over these intermediate periods and assumes that the investor holds every bond through maturity, which is infrequent in actively managed securities.
Indeed, most bond portfolios are rebalanced due to various factors including the investment/portfolio manager’s views on interest rates and duration management, views regarding how cheap or expensive a particular grade of bonds are trading relative to history, industry sector rotation, cash flow matching considerations, and changes in the benchmark risk factors. The realized capital gains or losses produced by buying and selling at varying market prices affect the performance independent of the original YTMs on the bonds.
The migration of credit and the risk of default should also be considered. Even in the absence of outright defaults, fluctuations in credit quality during a bond’s life can significantly impact pricing and returns if the security is sold prior to maturity. Tightening or widening credit spreads will impact mark-to-market values and realized performance. YTM does not factor in credit migration expectations unless they are already fully included in market prices at the time of purchase.
Yield curve dynamics, the curve shape and evolution over time also affect the returns of portfolios with different duration and convexity profiles. Two portfolios with the same weighted average YTM can perform differently when the yield curve changes in a non-parallel fashion as observed frequently in practice.
Investors therefore need to understand YTM is a useful but incomplete measure of return. Professional bond portfolio management is dependent on a more nuanced set of tools: horizon return analysis through various yield curve scenarios; total return decomposition (income, price change, roll-down, and currency effects); duration; key rate duration and measures of convexity; analysis of credit spreads and default risk; reinvestment rate assumptions consistent with policy forecasts or market predictions. Such techniques reflect the fact that fixed income returns are path-dependent and certainly not static as implied by a single YTM metric. Investors who simply look at YTM to measure return on a bond portfolio risk underestimating the complexity of portfolio management.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.