Bond Investing For Dummies
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Ultimately you can’t know the exact total return of any bond investment until after the investment period has come and gone, even though bonds are called fixed-income investments, and even though bond returns are easier to predict than stock returns. That’s true for bond funds, and it’s also true for most individual bonds (although many die-hard investors in individual bonds refuse to admit it).

Total return is the entire pot of money you wind up with after the investment period has come and gone. In the case of bonds or bond funds, that amount involves not only your original principal and your interest, but also any changes in the value of your original principal.

Ignoring for the moment the risk of default (and potentially losing all your principal), here are other ways in which your principal can shrink or grow.

Figure in capital gains and losses

In the case of a bond fund, your principal is represented by a certain number of shares in the fund multiplied by the share price of the fund. As bond prices go up and down (usually due to a number of factors, but primarily in response to prevailing interest rates), so too does the share price of the bond fund go up and down.

The share price of a bond fund may go up and down quite a bit, especially if the bond fund is holding long-term bonds, and doubly especially if those long-term bonds are of questionable quality (junk bonds).

In the case of individual bonds, unless you buy a bond selling at a premium, your principal comes back to you whole — but only if you hold the bond to maturity or if the bond is called. If, on the other hand, you choose to sell the bond before maturity, you wind up with whatever market price you can get for the bond at that point.

If the market price has appreciated (the bond sells at a premium), you can count your capital gains as part of your total return. If the market price has fallen (the bond sells at a discount), the capital losses offset any interest you’ve made on the bond.

Factor in reinvestment rates of return

Total return of a bond can come from three sources:

  • Interest on the bond

  • Any possible capital gains (or losses)

  • Whatever rate of return you get, if you get any, when you reinvest the money coming to you every six months

Believe it or not, on a very long-term bond, the last factor — your so-called reinvestment rate — is probably the most important of the three! That’s because of the amazing power of compound interest.

The only kind of bond where the reinvestment rate is not a factor is a bond where your only interest payment comes at the very end when the bond matures. These kinds of bonds are called zero-coupon bonds. In the case of zero-coupon bonds, no compounding occurs. The coupon rate of the bond is your actual rate of return, not accounting for inflation or taxes.

Example: Suppose you buy a 30-year, $1,000 bond that pays 6 percent on a semiannual basis. If you spend the $30 you collect twice a year, you get $1,000 back for your bond at the end of 30 years, and your total annual rate of return (ignoring taxes and inflation) is 6 percent simple interest.

But now suppose that on each and every day that you collect those $30 checks, you immediately reinvest them at the same coupon rate. Over the course of 30 years, that pile of reinvested money grows at an annual rate of 6 percent compounded.

In this scenario, at the end of six months, your investment is worth $1,030. At the end of one year, your investment is worth $1,060.90. (The extra 90 cents represents a half year’s interest on the $30.)

The following six months, you earn 6 percent on the new amount, and so on, for 30 more years. Instead of winding up with $1,000 after 30 years, as you would if you spent the semiannual bond payments, you instead wind up with $5,891.60 — almost six times as much!

Allow for inflation adjustments

Of course, that $5,891.60 due to 6 percent compound interest probably won’t be worth $5,891.60 in 30 years. Your truest total rate of return needs to account for inflation.

If inflation — the rise in the general level of prices — were 3 percent a year for the next 30 years (roughly what it has been in the past decade), your $5,891.60 will be worth only $2,366.24 in today’s dollars — a real compound return of 2.91 percent.

To account for inflation when determining the real rate of return on an investment, you can simply take the nominal rate of return (6 percent in our example) and subtract the annual rate of inflation (3 percent in our example). That gives you a very rough estimate of your total real return.

But if you want a more exact figure, here’s the formula to use:

1 + nominal rate of return / 1 + inflation rate – 1 x 100 = Real rate of return

Assuming a 6 percent nominal rate of return and 3 percent inflation:

1.06 / 1.03 – 1 x 100 = 2.91

Why the more complicated calculation? You can’t just subtract 3 from 6 because inflation is eating away at both your principal and your gains throughout the year.

Weigh pre-tax versus post-tax

Of course, taxes almost always eat into your bond returns. Here are two exceptions:

  • Tax-free municipal bonds where you experience neither a capital gain nor a capital loss, nor is the bondholder subject to any alternative minimum tax.

  • Bonds held in a tax-advantaged account, such as a Roth IRA or a 529 college savings plan.

For most bonds, the interest payments are taxed as regular income, and any rise in the value of the principal, if the bond is sold (and sometimes even if the bond is not sold), is taxed as capital gain.

For most people these days, long-term capital gains (more than one year) on bond principal are taxed at 15 percent. Any appreciated fixed-income asset bought and sold within a year is taxed at your normal income-tax rate, whatever that is. (Most middle-income Americans today are paying somewhere around 30 percent in income tax.)

About This Article

This article is from the book:

About the book author:

Russell Wild, MBA, an expert on index investing, is a fee-only financial planner and investment advisor and the principal of Global Portfolios. He is the author or coauthor of nearly two dozen nonfiction books.

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