Understanding Total Returns for Bonds

As part of my 2008 Finanical Goal, I plan to evaluate various types of bond investments, post about them and then select one for purchase. First, I want to examine how individual bonds provide returns.

Understanding stock returns is pretty straight forward - market price plus dividend, but Bond returns are a little more complex. In talking with friends and co-workers I realized that very few people are comfortable with how bonds work. In the book, Bogle on Mutual Funds, there is a very good explanation that I bookmarked for future reference. I have summarized Bogle’s description and added a few of my own comments, of course.

Bond returns are comprised of three items:

• Initial yield
• Reinvestment rate
• Impact of Rate change on market price

The primary factor by far is the initial yield – it is the major determinate of the future return on a bond.

One might assume that a bond with an 8% coupon would achieve a return of 8%, if held to maturity. This is not always correct, because of the reinvestment factor. US Govt bonds pay a semiannual interest coupon that is reinvested at the current rate (not the initial rate). If the new rate is less than 8% the return will also be lower and conversely if the reinvestment rate is higher the corresponding total return will also be higher. The following table illustrates the importance of the reinvestment factor for a 20 year Govt bond (8% coupon, $10,000 investment).

The third item, rate change, impacts the bonds market price and is only a factor if the bond is not held to maturity. An increase in rates will reduce the market value of a bond. Many have trouble with this concept. Here’s my explanation. If rates are increasing and you are holding a bond at a lower rate it is no longer as desirable (valuable) because better rates can now be had. You are locked in to your initial rate, but of course the semiannual coupon is being reinvested at this new higher rate. So not all is bad with raising rates – just don’t sell into that environment.

The table is somewhat misleading because rates rarely stay the same for 1 year let alone 20. For a 20 yr bond there will be 40 semiannual reinvestment dates. That will result in a lot of averaging of the overall reinvestment rate. The effect of averaging over a long time period explains why the impact of reinvestment rates is not the primary force in bond returns.