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.
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.
Add the income earnings of $1,000 to the current value of your fund ($9,000). Your investment is now worth $10,000. (For the sake of simplicity, we are ignoring interest-on-interest and commission costs.) Therefore, the net return is $0, or 0%. That is your total return, to date, even though you have received 10% interest income. Of course, if interest rates had declined, the price of your bond fund would have risen, and your capital gains would have added to the interest income your fund distributed, and your total return would have been higher than the interest income.
The concept of total return applies equally to individual bonds.
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