Analysis of Fixed Income Total Return

Francis Ng

Alternative to yield
Yield represents a return on investment if we hold the bond to maturity. What if you have no intention to hold it till maturity?

We can use the Total Return Analysis.

Popular among Fixed Income Fund Manager. Allow them to analyze various scenarios.

Total Return
There are 3 components to Total Return 1) Coupon income 2) Reinvestment income 3) Capital Gain

How to determine Total Return for a given investment horizon?

Total Return
P0 FVT,VT,, yT Horizon |--------------------------------------------------| t=0 1)

Compute the FV of [Coupon Payments + Interest on Interest] based on a reinvestment rate over the holding horizon. FVT = (C/r) * [ (1+r)n 1] where r = reinvestment rate and n is number of coupon payments

Total Return
2) Compute the horizon value VT of the bond based on remaining cash flows and discounted by assumed yield yT at T. Use Bond equation Total future dollars @ horizon = FVT + VT. Compute the semiannual total return: TR (sa) = [total future dollars]1/h - 1 (Price of bond t=0) where h is the number of 6-month periods in the investment horizon. 5) Annual Total Return = TR (sa) * 2
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3) 4)

Total Return
Example: A 20-year semi-annual bond pays 8% coupon is selling for $828.40. You have a 3-year horizon. YTM is 10 and the reinvestment rate is assumed to be 6%. At the end of 3 years, you expect the bond to sell at 7% YTM. Compute the Annual TR of the bond. Since bond is semi-annual, C = 4% every 6 months and reinvestment rate = 3% every 6 months. Number of periods is 6 (3*2) till horizon.

Total Return
1) FV of [Coupons + Interest-on-interest] FVT = (C/r) * [ (1+r)n 1] = ($40/0.03)*[ (1.03)6 1] = 1333.333*[0.194052] = $258.74 Interest-on-Interest = 258.74 (40*6) = $18.74 Horizon Value of bond VT @ yield = 7%. Since there are 17 years left till maturity, then VT = ($40/0.035)*[1 1/(1.035)34] + 1000/(1.035)34 = $1,142.85 * (0.689524) + $310.476 = $788.03 + $310.48 = $1098.51
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2)

Total Return
3) Total future dollars = FVT + VT = $258.74 + $1098.51 = $1,357.25 Semi-annual total return TR (sa) = [$1,357.25/ $828.40](1/6) 1 = 1.08576 1 = 0.08576 = 8.576% TR = 2 * TR(sa) = 2 * 8.576 = 17.152%

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Total Return
Why bother with Total Return?

Very useful for portfolio manager He/she can change the reinvestment rate He/she can change the yield assumption at horizon He/she can change the investment horizon assumption. He/she can perform multiple scenarios based on different yield expectations and risk changes.