Bond Primer: Yield vs. Total Return

The following is a guest post from Sound Mind Investing. Here's a review of SMI if you're interested. It's a basic piece (hence "a primer") but I'm sure some of you will find it very educational. And the rest of you can discuss what you think the interest rate risk is on today's bonds. Seems high to me given that interest rates are so low these days -- they can't go lower, can they?

A bond is simply an IOU. An investor lends money to a corporation or a government (federal, state, local) and in return gets the promise of regular interest payments, as well as the full return of the loan at the end of a specified period.

Bond investing carries two major risks. The first is that the business or government might run into serious financial troubles not be able to pay up. This is called "credit risk." The second risk is that you might get locked into a below-market rate of return (explained below). This is called "interest-rate risk."

When offering a bond in the marketplace, the issuer promises a certain "yield." For example, you might find a $1000 bond offered with an annual yield of 6%. In other words, that bond would pay $60 a year in interest (6% of $1,000).

But "yield" is only one aspect of what your bond investment will be worth going forward. Suppose interest rates were to fall after you make your $1,000 investment. For bondholders, that's a good thing, because when rates fall, bond prices rise (after all, you own a bond paying 6%; newer bonds might be paying only 5%). Someone may want to buy your bond so they can get a higher interest rate than currently available among new bonds.

Because your bond is in demand, let's say you can sell it after three years for $1,100. You now have a $100 capital gain. When you combine the yield and the gain you have what is called total return. This total is usually expressed in annual compounded terms.

In our example, you invested $1,000 and received back $1,280 over three years ($180 in interest payments — i.e., $60 a year — plus a $100 gain when you sold). To learn what your total return is in annual percentage terms, you ask, "What rate of growth would be required to turn $1,000 into $1,280 in three years?"

Using an online calculator that can perform time-value-of-money computations, you learn that it takes about an 8.6% per year rate of growth to do that. (In other words, if you had invested your $1,000 at 8.6% for three years, you would have had approximately $1,280 at the end of that time.)

What this means is that the 6% yield you received as you went along, plus the $100 gain at the end, made it possible to achieve a very nice 8.6% annualized total return.

But suppose interest rates rose after you bought your $1,000 bond? As a result, the bond's value dropped by $100 (this is the interest-rate risk referred to above). Now, newer bonds have a higher rate than your bond, so if you want to sell your bond, you’ll have to lower the asking price.

You don't have to sell your bond, of course, but suppose you need some cash, so after three years you sell your $1,000 bond for $900, taking a $100 loss. You would still have $180 in dividends ($60 for three years), but when you subtract the $100 loss on the price, you'd have only $80 to show for your efforts. While you thought you were earning 6% a year, it turns out you were actually netting, on average, just 2.6% per year (once the capital loss is subtracted from the yield).

As you can see, a bond's yield tells only part of the story. What you're really interested in is your eventual total return.

Being aware of the difference between yield and total return is especially important right now with interest rates being so low and the potential for inflation on the horizon (due to so much money being pumped into the system by the Fed). Inflation, or even a growing concern about future inflation, causes bond buyers to demand a higher return on their money to protect their future purchasing power. That means today's bond buyers could face significant interest-rate risk ahead.

So if you’re investing in bonds in today's climate, it's probably best to keep maturities short (1-to-3 years). Short-term bonds have much less interest-rate risk than long-term bonds.

Comments

[Robert]

Sound Mind Investing has great advice. Good detailed look at finances. Great post.

[Old Limey]

As a serious student of stockmarket trends, particularly the summations of New Highs vs New Lows and the summations of Up Volume vs Down Volume for the NYSE and the NASDAQ I started to see the writing on the wall months before it happened and moved everything into money market funds (MMF).

By October 2008 the yield on MMFs was pitifully low so I loaded up my taxable account 100% with individual muni bonds. Since growth is no longer an issue for me and I don't need capital gains I was looking primarily for Federal and AMT tax exempt income. At the time it was easy to find good quality bonds with a 4.5% to 5% coupon at prices beween $950 and $990/bond. I laddered them out between 2010 and 2021 and intend to hold them all to maturity. This way I can generate tax free income (Avg. 4.9%), far higher than keeping my money in a MMF, avoid the AMT tax, still make a little profit on them as they reach maturity and not worry about market volatility and fluctuations. Currently, one year later, muni bonds have appreciated to the point however where it's almost impossible to find a 5% coupon at par value, and if you pay the premiums that the sellers are asking it makes little sense to buy them if you intend holding them to maturity since you would be buying at $1100 - $1150/bond and have a substantial capital loss when they mature at $1000/bond.

Even though my brokerage shows them to be worth a lot more than I paid for them I use the value at maturity in my own accounting. There are no account fees or other expenses, it's just a matter of reinvesting the income that each bond pays every six months. I am accumulating the income in a good, tax free muni bond mutual fund so that I can raise some cash in a hurry should I need to.

You talk about inflation in your article however some eminent economists are predicting a deflationary environment in the future. We will just have to wait and see who is right. Currently the American consumer seems to have tossed away his credit cards, is saving money or paying off debt, and not in a buying mood. Inflation usually requires that companies can keep raising prices - I don't see that happening. Even restaurants seem half empty and are offering lots of 2 for 1 deals. The unemployed and the underemployed are eating at home and not frequenting the shopping malls.

[Financial Samurai]

I honestly honestly think the bond market is OVERPRICED right now with the 10 yr yielding only 3.35%.

That said, I feel the stock market is also overpriced, hence one should be getting defensive and raising cash.

Don't get greedy folks!

[kitty]

@Old Limey -- good thinking buying individual bonds during the credit crisis. I did the same, though I was a bit cash-short at the time: I needed to either break CDs or sell stocks at low prices to raise more money, and I didn't want to do either. So I only spent cash I had - enough for a couple issues of AA and AAA munis and a couple issues of corporate bonds which were seriously undervalued (Goldman Sachs and Wells Fargo). The rate was 5 and 5.25% municipal bonds, but because I bought at a discount, the actual yield to maturity is 5.5%. On corporate bonds, the rate was 6%, but I bought at very large discount, so yield-to-maturity is between 8 and 9%.

Now all of these bonds are up in value, so this is a dilemma. Like you, I use their face value in my calculations. But if I look at the current price, the actual yield on the current value of the bond is much lower. I.e. if I were to sell it, and pay capital gains tax, would I get more or less on this new amount. I plan to keep doing this calculation and sell (at least corporate bonds) if I feel that the return is no longer good or if I feel the time the interest rates would go up is close. Not sure about munis - tax free income is very attractive.

" if you pay the premiums that the sellers are asking it makes little sense to buy them if you intend holding them to maturity since you would be buying at $1100 - $1150/bond and have a substantial capital loss when they mature at $1000/bond."

Yes, but isn't this already reflected in yield-to-maturity column? So shouldn't you simply compare yield-to-maturity with the return you can be getting elsewhere? Especially when you talk about municipal bonds, buying a bond at a premium may still be attractive in your tax bracket: the years of tax free return may well compensate the loss in principal. Especially if you deduct the loss on your tax return.

I am not saying bonds are a good deal now - same reason that Financial Samurai mentioned. In fact, I plan to move money I have in bonds in my 401K (where we can only have funds, so no option to wait till maturity) into stable value probably next week. I am also seriously considering selling my corporate bonds (after doing some calculations). May wait until next year with individual bonds though -- too many capital gains this year and no immediate risk of rate hikes.