Why is Yield to Maturity (YTM) important for fixed income ETFs?
With rising interest rates and bond yields recently, fixed income ETFs are becoming popular to investors, and one of the most important metrics when investing in fixed income ETFs is the concept of "Yield to Maturity".
What is Yield to Maturity?
Yield to maturity of a bond is the rate of return at which the present value of all cash flows (interest and principal) generated by a bond, if purchased at today's price and held to its promised maturity date, will equal the price at which it was purchased. Simply put, you can think of it as the expected return you can expect if you hold a bond to maturity.๐ (YTM Explained)
Do fixed income ETFs have a Yield to Maturity as well?
Since fixed income ETFs are basically funds that hold a variety of bonds, it is possible to calculate yield to maturity for bond ETFs by averaging YTM of all bond holdings. In the case of HYG, a U.S. high yield bond ETF, you can see that the "Portfolio Characteristcs" section of the website provides the value of the "Average Yield to Maturity", which is the average YTM of the bonds held.
Can the ETF's Yield to Maturity be used as a good proxy for the expected return on the ETF investment?
The answer is YES, and that's what this post is about. The YTM and the realized return could diverge due to the changing nature of the benchmark index that an ETF tracks. However, we can expect this correlation to be meaningfully higher for ETFs with relatively short average maturities.
Validate the correlation between the Average Yield to Maturity and the realized return of an fixed income ETF investment
For all following data validation, I will use the case of the US High Yield Corporate Bond ETF (HYG). The benchmark index that HYG are tracking is the iBoxx USD Liquid High Yield Index, but due to data accessibility, I used the Bloomberg US Corporate High Yield Index, which is almost identical in nature.
I'll share a Google Spreadsheet with all the process and results at the bottom, so you can follow along with the post as you watch.๐
Data preparation
I prepared daily data of the Total Return Index, Duration, and Yield to Worst values of the Bloomberg US Corporate High Yield Index for the period 2001-01-01 to 2023-03-06 (columns "A" to "D" in the "Data" sheet). I used Duration and Yield to Worst as proxies for the ETF holding period and the Yield to Maturity for convenience.
Since My goal is to compare Yield to Maturity with the realized return of the ETF's holding period, I calculated the following values in columns "E" and "F".
- TR Index after Duration : Total Return Index value after holding for the duration.
- Realized Annual Return(arithmetic) : Calculate the return of Total Return Index for the period and then annualize it.
Correlation test results
Based on the prepared data, I compared the Yield to Worst (%) and Realized Annual Return (%) of the indexes for the period 2001-01-01 to 2020-02-18.
As you can see in the time series chart below, two values are highly correlated over this period. Of course, there is a divergence between 2004-2005, when the US Fed's policy rate steeply hiked, and 2019-2020, when corporate bond spreads increased sharply because of COVID19.
The high correlation can also be seen in the Dot Plot, which shows that the two returns, Yield to Worst(%) and Realized Annual Return(%), are highly correlated, with a Correlation Coefficient of 0.87 and an R-squared of 0.76.
Conclusion
I have demonstrated that the Yield to Maturity can be used as a good proxy for the expected return of an fixed income ETF investment. Of course, there can be a divergence depending on the macro environment, such as the level of interest rates and credit risk, and it is reasonable to assume that this divergence will be greater for ETFs with longer average bond maturities (higher duration).
It was also a new insight to see how rare it was for the US High Yield Corporate Bond ETF to have a negative holding return (assuming holding for the duration) over the 20+ year period. If the Fed's rate hikes stabilize, I can expect good market timing for US High Yield ETFs to earn as much as Yield to Maturity indicate.