July 06, 2020

Yield vs. Return

An investor reached out to me with questions related to a certain floating rate fund.  The fund had reported its May-end net portfolio yield (i.e. after expenses) to be ~6.5% p.a..  How was it then, he asked me, that over the month of June, it had shown an annualized return of ~23% p.a.?  If it was, as he suspected, somewhat linked to the last round of rate cuts by RBI, then why was it that other funds that had relatively higher yields as well as higher duration, hadn’t gained as much as this fund?

His suspicion was not without merit.  Such a difference in return over yield is usually seen at times when RBI cuts interest rates.  It’s just that, this time around, bond yields have been taking their time to adjust to the cuts.  While RBI cut rates in March and May, some of the expected fall in yields played out only over June. 

However, there are a couple of things that the investor overlooked.

Firstly, the fall in yields in June wasn’t uniformly across the yield curve, or issuers, and there were some striking differences in returns across funds and fund categories.  For instance, the category that gave the best return was that of corporate bond funds yet the best performing fund across categories was a credit risk fund.  While the categories of short and medium duration funds did better than ultra short and low duration funds, gilt funds, despite their much longer duration, gave lesser return than all these categories.  In a nutshell, it boiled down to the individual securities that a fund was holding. 

In that light, if I look at the May-end portfolio of the aforementioned floating rating fund, some part of its extraordinary gains in June would have been driven by a ~100 bps fall in yields of two AAA bonds, with 3-4 years left to their maturity, and which made up ~10% of the portfolio.  In addition, some gains would have resulted from a 30 to 55 bps fall in the yields of perpetual bonds that the scheme was holding, and which made up ~18% of the portfolio.  In the aftermath of what happened with Yes Bank, across-the-board, yields of perpetual bonds shot up and have remained high ever since.  Only in June did those yields show signs of softening.

I must point out that all that I said just now assumes that those securities continue to be held in the fund’s portfolio.  We will know for sure, once the June-end portfolio is disclosed.

Secondly, at a more conceptual level, while the portfolio yield of a debt fund is the single most important indicator that an investor should examine and track, it has its own limitations.  Yes, it can give clues as to the level of credit risk in a fund, as well as roughly indicate what might be the immediate return that one could expect.  However, yields change daily whereas fund houses disclose the yields only at the end of each month.  Thus, in a period of sharp changes in yields, the last month-end yield will be of limited use.

In addition, if a fund holds illiquid or thinly traded securities, then the fund’s yield may not be a true measure of how the market may value its portfolio.  Selling those securities can well bring about gains or losses to their portfolio values.

To illustrate this point, I’d like to take the example of a fund whose reported net yield as of May-end was ~12% p.a. but which ended up giving a negative return over June, and not because of any markdown or default.

This scheme held a certain security that alone made up almost a third of the portfolio, and which was valued at an estimated yield of ~16% p.a..  For some reason, the fund manager chose to sell some of that security in June.  As it happens, the sale was made at a yield of 28% p.a..  In other words, the fund got a lot less money than what the security had been valued at.  That led to the NAV falling by ~1.5% that day, and that alone was enough to wipe out whatever gains the reported yield would have brought about over the entire month.

To be fair, this may be an extreme example.  Still, it should help drive home the perils of blindly relying on a  fund’s portfolio yield.

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