I find that the yield to maturity (YTM) of debt funds is much lower than the trailing returns over the last one, three- or five-year periods. If I invest now and wait for three years, will my returns be closer to the YTM or to the trailing returns?
Yes, the YTM and the trailing returns can be significantly different. Just to explain the difference, trailing returns is essentially a backward-looking measure which tells you about the actual returns a fund has generated in the last one-three or five years or whatever time period.
On the contrary, YTM is essentially a forward-looking metric which gives you an indication of the expected returns from a fund from here on, should the portfolio of the fund be held till maturity. Typically, YTM gives a relatively better indication of the expected returns of a fund in case of closed-end funds or fixed-maturity plans because over there, once the portfolio is constructed after the fund is launched, the idea is to hold that portfolio till maturity and in the interim, there are really no inflows or outflows that hit the fund. So, until and unless there are any credit defaults that the fund has to face, the YTM at the time of launch could be a fairly good indicator of the actual expected returns from the fund. In the case of open-end fixed-income funds, the YTM is not as good an indicator of the expected returns, as the fund witnesses inflows and outflows all the time. Further, fresh money has to be deployed at the then-prevailing yields. Also, the portfolio itself might be relatively more dynamically managed and there could be bonds that make their way into the portfolio or out of the portfolio. That's why the actual returns could be fairly different from what the YTM suggests at any given point of time.
Typically, YTM can be much lower than the trailing returns during the times of falling interest rates, as in the kind of time that we've just been through. If you look at what should be one's expectation from here on, I'd say that over the next one year, you should not expect the kind of returns that the trailing returns seem to suggest because of the falling interest rates which help prop up the bond prices. The trailing returns of many bond funds seem to be pretty good but that should not be the criteria for you to set your expectations for the next one-year period, where I'd say your return expectations should be closer to what the YTM figures suggest. Over a three-year horizon which he's asked for, it's a slightly longer shot and really difficult to predict what kind of returns one would get, but I'd say that it should fall somewhere in between what the trailing one-year return suggests or what the YTM suggests. So, while the returns may not be as good as what we see in the trailing one-year returns, hopefully, they should not be as low as what the YTM suggests either.