The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

TOTAL RETURN

At the time of purchase, an investor is promised a yield, as measured by the yield to maturity, if both of the following conditions are satisfied: (1) The bond is held to maturity, and (2) all coupon interest payments are reinvested at the yield to maturity. We focused on the second assumption, and we showed that the interest-on-interest component for a bond may constitute a substantial portion of the bond’s total dollar return. Therefore, reinvesting the coupon interest payments at a rate of interest less than the yield to maturity will produce a lower yield than the yield to maturity.

Rather than assume that the coupon interest payments are reinvested at the yield to maturity, an investor can make an explicit assumption about the reinvestment rate based on expectations. The total return is a measure of yield that incorporates an explicit assumption about the reinvestment rate.

The idea underlying total return is simple. The objective is first to compute the total future dollars that will result from investing in a bond assuming a particular reinvestment rate. The total return is then computed as the interest rate that will make the initial investment in the bond grow to the computed total future dollars.

The procedure for computing the total return for a bond held over some investment horizon can be summarized as follows:

Step 1. Compute the total coupon payments plus the interest-on-interest based on the assumed reinvestment rate. The reinvestment rate in ...