Introduction to Fixed Income Analytics: Relative Value Analysis, Risk Measures, and Valuation, Second Edition

CHAPTER 11

Total Return

An investor who purchases a bond can expect to receive a dollar return from one or more of the following sources: (1) the coupon interest payments made by the issuer; (2) any price appreciation/depreciation when the bond matures, is called, is put, is refunded, or is sold; and (3) income from reinvestment of the coupon interest payments (i.e., interest on interest). Any measure of the potential return from holding a bond over some investment horizon should consider these three sources of dollar return. In Chapter 5, we explained why yield measures are limited with respect to assessing the potential performance over some investment horizon. In this chapter, we set forth a framework to assess the potential performance of a bond or bond strategy—total return.

COMPUTING THE TOTAL RETURN

The total return considers all three sources of potential dollar return over the investor’s investment horizon. It is the return (interest rate) that will make the proceeds (i.e., price plus accrued interest) invested grow to the projected total dollar return at the end of the investment horizon.⁶⁵ The total return requires the investor to specify:

• An investment horizon.

• A reinvestment rate.

• A price for the bond at the end of the investment horizon.

More formally, the steps for computing a total return over some investment horizon are as follows:

 

Step 1: Compute the total coupon payments plus the reinvestment income based on an assumed reinvestment rate. The reinvestment ...