The Ins and Outs of Bond Yield
Step 4: What Makes Up My Bond's Total Return?
Investors in fixed-income securities sometimes make the mistake of equating interest income or advertised yield with return. But this does not take into consideration what is happening to principal.
Classroom Steps
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Step 1:
What Determines the Return on My Bond? -
Step 2:
Why Are There Different Bond Yields? -
Step 3:
How Is Yield to Maturity Calculated? -
Step 4:
What Makes Up My Bond's Total Return? -
Step 5:
Do Bond Funds Have a Yield to Maturity? -
Step 6:
How Should I Interpret My Bond's Reported Return?
Total return for bonds consists of whatever you earn in interest income, plus or minus changes in the value of principal. (To be totally accurate, you would also subtract taxes and commission expenses from return.)
For example, let's assume that a year ago, you invested $10,000 in a bond fund, purchasing 1,000 shares at $10.00 each. Assume also that the bond fund was advertising a yield of 10%, or $1.00 per share, which was maintained for the entire year. But suppose that in the meantime, interest rates have risen so that now bond funds with similar maturity and credit quality yield 11%. As a result, your bond fund is now selling for $9.00 per share. What is the total return on that investment for the past year?
You have earned interest income (based on the monthly coupon distributions) of 10%, or $1,000. But, that ignores the fact that your bond fund has now lost approximately $1 per share (10% of its principal value) and that your principal is now worth $9,000.
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