As discussed in Chapter 10, the concept of total return (TR) methodology is a robust measure of expected returns over a defined horizon. This analysis is commonly used by investors that manage assets versus market benchmarks or indexes, as well as by investors looking to evaluate and compare projected performance under different interest rate scenarios. In the following section, we demonstrate some ways that TR analysis can be used, using the same three bonds evaluated in Exhibits 12.11
Total return is arguably a more realistic and robust measure of performance than yield for a number of reasons. Most importantly, it relaxes some of the unrealistic assumptions underlying yield measures; it allows for the assumption of different reinvestment returns, as well as the prospect that the bond will be held to a predefined horizon, rather than to maturity. It also allows returns to be generated under a variety of different interest rate and prepayment scenarios. However, this increased flexibility means that some assumptions must be explicitly made prior to generating the analysis. These assumptions include:
• The method used to determine the terminal price of each security at the horizon. Often, an assumption of constant OAS is made, meaning that the bond’s price is regenerated at a point forward in time, using the current level of OAS as the pricing benchmark. Other spreads, such as static spreads over swaps, can also be used, along with user-defined ...