Credit risk and yield-to-maturity in debt funds

Two investors compare debt funds. One picks the higher YTM, reasoning that a higher yield is a better return. That single decision is how most debt-fund disasters begin.

YTM is not a promise. In a debt portfolio it is often a warning, and reading it alongside credit quality is the whole skill.

What YTM actually is

Yield to Maturity is the annualised return a bond would deliver if you bought it at today’s price and held it to maturity, collecting every coupon and the principal on schedule.

For a fund, the disclosed portfolio YTM is the weighted average across all its holdings. It is genuinely useful: it makes bonds with different coupons, prices and maturities comparable on one number.

Three things it assumes, all of which can fail:

1. Every issuer pays in full and on time. If one defaults, the realised yield is not the YTM — it is materially lower.
2. You hold to maturity. An open-ended fund does not; it trades, and unitholders come and go.
3. Coupons are reinvested at the same rate. Rates move.

And one thing it does not include: the expense ratio. Your expected return is roughly portfolio YTM minus the expense ratio, before any credit event.

Why a high YTM is usually a disclosure, not a bargain

Bond markets are competitive. If a portfolio yields materially more than its peers, it is being paid more for a reason, and there are only three:

• It has taken more credit risk — lower-rated issuers who must offer more to borrow.
• It has taken more duration risk — longer maturities, which pay more and swing more when rates move.
• It holds less liquid paper that cannot be sold quickly at a fair price.

None of these is free money. A short-duration fund yielding 1.5 percentage points above its category is not cleverer than its peers; it is holding something they declined to hold. The duration and credit axes explain which risk you are being paid for.

Reading credit quality

Every debt scheme discloses its rating profile. What to look for:

• AAA / Sovereign — the highest tier. Government securities carry no meaningful credit risk at all.
• AA — sound, and where a genuine yield pickup begins.
• A and below — this is where defaults live. A credit risk fund must hold at least 65% here by mandate; that is the product, and it is honest about it.

Two things matter more than the headline average:

Concentration. A portfolio that is 95% AAA and 5% in a single weak name can lose more than one spread evenly across many AA issuers. Look at the largest single-issuer exposure, not just the rating mix.

Ratings are lagging indicators. Downgrades typically follow trouble rather than predicting it, and Indian credit history has several instances of paper falling several notches in a matter of days. A rating is a starting point, not a guarantee.

What a credit event actually does

When an issuer defaults, the fund writes the holding down and the NAV drops immediately. If the paper is illiquid, the AMC may create a segregated portfolio (a side pocket): your units in the healthy part continue normally, and you receive separate units for the distressed part that pay out whatever is eventually recovered — often much less than face value, sometimes years later.

Unlike a rate-driven fall, this does not reverse by waiting. It is a permanent impairment, and it is the reason this site excludes side-pocketed schemes from every screen and ranking: their NAV describes an event, not a fund.

Pitfalls to avoid

• Do not rank debt funds by YTM. You are ranking them by risk taken.
• Do not forget to subtract the expense ratio. A 7.6% YTM with a 1.1% ratio is a very different proposition from 7.4% with 0.25%.
• Do not use a credit risk fund as a cash substitute. It is a considered bet on being paid for default risk, sized accordingly or not held.
• Do not assume “AAA fund” means safe. It removes credit risk and leaves duration risk entirely intact.
• Do not chase the top of a debt-fund return table. Last year’s best debt fund is frequently the one that took the risk that has not yet shown up.

Key takeaway

YTM is the return a debt portfolio would earn if nothing went wrong, before costs — which makes an unusually high one a description of the risk taken, not a forecast of the return earned. Read it beside the rating profile, the largest single-issuer exposure, the duration and the expense ratio. In debt, the higher-yielding fund is almost never the better one; it is the one being paid more to take something you may not want.