Total Return For Bonds

The total return earned on any investment during a year equals its income plus any price gains or minus any losses. For multiyear periods, the interest earned on the reinvested interest exerts a big overall influence. Bondholders who do not understand this may be doing worse than they think. The following example demonstrates the impact of compounding.

Suppose you buy a 10% coupon bond at par ($1,000). The investment pays annual interest and matures in 25 years. You hold to maturity. Would you realize a 10% yield to maturity (y-t-m), also known as the true compound rate of return? The answer depends on what you do with the interest payments, which total $2,500 over the 25 years ($100 per year times 25):

1. If you spent the interest checks, your yield to maturity would be 5.1%.

2. Instead, suppose you reinvested the annual interest payments in a 4% passbook account. You would accumulate $4,165 in interest, but your realized yield to maturity would be 6.8%.

3. To earn the full 10% y-t-m, you would have to reinvest each payment at 10%. The accumulated interest would amount to $9,835.

When you buy a bond, you cannot necessarily tell what you will be earning over its life because of the uncertainty as to the rate of return earned on interest payments not spent by the investor. The important point to remember is that interest on interest, or compounding, is a powerful concept. The longer you hold onto a bond or bond fund, the more significant compounding becomes. By reinvesting all interest payments or distributions, you will realize a better return. The next table shows two different parts of a bond’s annual return (interest payments plus appreciation or minus depreciation). The figures are for a U.S. government long-term bond. The purpose of showing this breakdown is to provide an understanding of principal appreciation/depreciation (when rates change) and how much interest payments affect total return.