Calculating Fixed-Income Returns: Easier Said Than Done
Bonds differ greatly as far as risk, expected return, taxability, sensitivity to various economic conditions, and other factors. Because of this, calculating fixed-income returns is quite difficult.
So you invest in a $1,000 bond that yields 6 percent and matures in 20 years. What do you do with the $30 coupon payments that you receive every six months? Do you reinvest them or spend them on Chinese dinners? Do you keep the bond for the entire 20 years or cash it out beforehand? (If the bond is callable, of course, you may have no choice but to take back your principal before maturity.) And if you do cash out before maturity, what kind of price will you be able to get for the bond?
And what about the real (after-inflation) rate of return — the return that really matters? If inflation runs at 2 percent, your real return will be a lot greater than if inflation runs at 8 percent. But how can future inflation be predicted?
And what if you invest in a bond fund? Just because the fund yielded, say, 5 percent annually over the past seven years, does that mean it will yield that much moving forward?
And (sorry, just a couple more questions here) what about after-tax real return (return after both inflation and taxes)? Ultimately, that’s the return that matters the most of all. That’s the return that moves you ahead financially or sets you back. Do you know what your tax bracket will be in ten years? Do you know what anyone‘s tax bracket will be in ten years?
These are just some of the questions that make bond investing — or any kind of investing — so much fun!