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Total Return Analysis

By Jonathan D. Jones, Senior Financial Economist

(202) 906-5729

Introduction ments. The 1998 FFIEC policy

statement states: “The agencies [i.e.,
the expected return of fixed-income
securities. In evaluating the expect-
the FRB, FDIC, OCC, OTS, and ed return of an individual fixed-
Last year, both the Federal Financial NCUA] agree that the concept of income security, or portfolio of
Institutions Examination Council total return can be a useful way to fixed-income securities, investors
(FFIEC) and the Office of Thrift analyze the risk and return tradeoffs typically use internal rates of return,
Supervision (OTS) issued policy for an investment. This is because such as yield to maturity or yield to
guidance that recommends institu- the analysis does not focus exclu- call, as selection criteria. These two
tions conduct a total return analysis sively on the stated yield to maturi- yield measures, however, are unlike-
in assessing the effects of interest ty. Total return analysis, which ly to reflect the correct expected
rate changes on the returns associat- includes income and price changes investment return. Instead, total
ed with investment securities and over a specified investment horizon, return provides a better measure of
financial derivatives prior to taking is similar to stress testing securities prospective investment return.
a position in these financial instru- under various interest rate scenarios.
The agencies’ supervisory emphasis
on stress testing has, in fact, implic-

Office of Thrift Supervision

itly considered total return. Conventional
Measures of
Therefore, the agencies endorse the
Risk Management Division use of total return analysis as a use-

Anthony G. Cornyn, CFA

ful supplement to price sensitivity
analysis for evaluating the returns
Investment Return
Director, Risk Management for an individual security, the invest-
ment portfolio, or the entire institu- The price of a bond is equal to the
Sarah Bryant, Ph.D. tion.” In Thrift Bulletin 13a, issued present value of the bond’s expected
Donald Edwards last year, OTS states: “Management cash flows. By definition, the yield,
Radu Filimon, Ph.D. should exercise diligence in assess- or internal rate of return, is that
Eberhard Irmler ing the risks and returns (including interest rate that equates the present
Cezary M. Jednaszewski expected total return) associated value of a bond’s cash flows to its
Jonathan D. Jones, Ph.D. with investment securities and current market price. Yield to matu-
financial derivatives.” rity (YTM) and yield to call (YTC)
Office of Thrift Supervision are two frequently used measures of
1700 G Street, N.W. This Risk Management Release dis- return (or yield) on fixed-income
Washington, D.C. 20552 cusses total return analysis and securities. YTM is used to price and
shows how it can be used to measure trade non-callable bonds, while

Risk Management Series

June 1999
Office of Thrift Supervision

YTC is used to price and trade n Capital gain or loss when a bond where r and h are defined as above,
callable bonds. matures, is sold, or called, and and

YTM is the internal rate of return on n Income from reinvestment of Total future dollars =
a non-callable bond that is held until coupon interest payments (inter-
maturity. In using this yield mea- est-on-interest income). Coupon payments
sure, one assumes that the security is + Interest-on-interest income
held until maturity and that all cash Therefore, to calculate the total + Sales price.1
flows can be reinvested at the same return for a non-callable bond, an
constant YTM. YTC is the internal investor chooses an investment hori-
rate of return on a callable bond that zon or holding period, a reinvest-
is held until either the first call or ment rate, and a selling price for the Total Return
Analysis in Practice
first par call date. In using this yield bond at the end of the investment
measure, one assumes that the secu- horizon (i.e., end-of-period required
rity is held until being called by the return). Based on the values chosen
issuer and that all cash flows can be for these parameters, the total return There are several different
reinvested at the same constant calculation is straightforward. First, approaches that could be used to
YTC. total coupon payments plus interest- calculate total return. First, an
on-interest income are calculated for investor, or portfolio manager, could
Both of these return measures have the assumed reinvestment rate over calculate total return on the basis of
several important drawbacks. First, the given investment horizon using subjective forecasts of the reinvest-
investors typically do not hold the following expression: ment rate and required yield at the
fixed-income investments until end of the investment horizon.
these investments mature or are where Second, implied forward rates from
called. Second, interim cash flows the yield curve (e.g., U. S. Treasury
cannot be reinvested at the assumed Coupon plus interest-on-interest = or LIBOR yield curves) could be
constant yields. Finally, it is not used to determine the reinvestment
possible to compare the likely (1+r)h - 1 rates and the yield on a bond at the
returns on investments with differ- r end of the investment horizon. This
ent maturities or more complex approach to total return analysis
return/risk profiles. h = length of investment horizon, produces what is called an arbitrage-
and free total return because the calcula-
r = assumed reinvestment rate. tion is based on the market’s
expectations of the reinvestment
Total Return rate and end-of-period required

Analysis in Theory
Second, the predicted sales price of yield. Finally, scenario analysis
the bond at the end of the investment could be used to calculate total
horizon is calculated. Third, total return. Scenario analysis involves
Total return analysis avoids the future dollars derived from the bond specifying different possible values
shortcomings associated with using over the holding period are calculat- for the reinvestment rate and the
the two conventional yield mea- ed by summing total coupon pay- required yield at the end of a given
sures, YTM and YTC, and provides ments, reinvestment income, and the investment horizon, and then calcu-
an investor with a better measure of predicted sales price. Finally, this lating the total return associated
the expected return on fixed-income value is substituted into the follow- with each scenario.
investments. The total return (also ing expression to obtain the total
known as the horizon or total hold- return: Of the three approaches, total return
ing-period return) accounts for the analysis based on scenario analysis
three sources of potential dollar is the best approach because it
return on a bond: 1/h allows an investor, or portfolio man-
Total future dollars
yh = -1 ager, to measure how sensitive a
n Coupon interest payments, Purchase price of bond bond’s expected performance is to

1 This discussion draws on material from Frank J. Fabozzi, editor, The Handbook of Fixed Income Securities, 5th Edition, 1997, Chapter 4.
See this chapter for further discussion of the total return concept.

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Risk Management Series

differing reinvestment rates and As shown in the tables, there are The second example compares the
end-of-period required yields. Total three different reinvestment rates, 4, total returns for two bonds of differ-
return analysis can also be used to 5, and 6 percent, and three different ent maturities. The first bond, Bond
compare the expected returns of a end-of-period required yields, 6, 8, A, is the same bond used in the pre-
bond for investment horizons of and 10 percent. In both tables, for vious example. The second bond,
varying lengths. In the two exam- each combination of reinvestment Bond B, is a 7.25 percent coupon,
ples that follow, scenario analysis is rate and end-of-period yield, there is 14-year non-callable bond with a
used to compare: (1) the total a total return estimate for Bond A. current market price of $94.55 and a
returns for a bond using two differ- yield to maturity of 7.9 percent.
ent investment horizons, and (2) the As shown in the two tables, the total (This example is adapted from
total returns for two bonds of differ- return estimates vary substantially Fabozzi, The Handbook of Fixed
ent maturities. across the two investment horizons. Income Securities, 5th Edition,
The differences in the total return pages 72-75.) In comparing the
To assess the effect on a bond’s total estimates illustrate the effect that the total returns for the two bonds
return of varying the length of the choice of investment horizon has on below, the investment horizon is set
investment horizon using scenario a bond’s expected return since the to three years. On the basis of yield
analysis, assume a bond, say Bond relative importance of the reinvest- to maturity, Bond A appears to be a
A, is a 9 percent coupon, 20-year ment rate and end-of-period better investment than Bond B
non-callable bond with a current required yield is related to invest- because of Bond A’s higher yield to
market price of $109.90 and a yield ment horizon. For short investment maturity. However, as the example
to maturity of 8 percent. Tables 1 horizons, for example, reinvestment shows convincingly, yield to maturi-
and 1A show various scenarios for income is small, but it increases in ty is not a reliable measure of
the reinvestment rate and end-of- size as the investment horizon expected investment return.
period required yields for Bond A lengthens.
for a three-year and ten-year invest- Table 1 (left) and Table 2 (page 4)
ment horizon, respectively. show various scenarios for the rein-
vestment rate and end-of-period
required yields for Bond A and
Table 1. Scenario Analysis for Bond A’s Total Return Bond B, respectively. There are
Required Yield at End of
three different reinvestment rates, 4,
3-Year Investment Horizon (%)
5, and 6 percent, and three different
end of period required yields, 6, 8,
6.0 8.0 10.0 and 10 percent. These are the same
Reinvestment Rate (%) values used in the previous example.

4.0 13.36 7.78 3.06 The total return estimates for both
5.0 13.44 7.87 3.16 bonds vary substantially across the
6.0 13.53 7.97 3.26 different rate scenarios. For Bond A,
these estimates range from a maxi-
mum value of 13.53 percent to a
minimum value of 3.06 percent. For
Bond B, these estimates range from
Table 1A. Sensitivity of Bond A’s Total Return a maximum value of 12.16 percent
to Investment Horizon to a minimum value of 3.48 percent.
Required Yield at End of This example shows the high degree
10-Year Investment Horizon (%) of sensitivity of a bond’s expected
return to different values for rein-
6.0 8.0 10.0 vestment rates and end-of-period
Reinvestment Rate (%) required yields.
4.0 7.59 6.88 6.24 If a portfolio manager currently
5.0 7.85 7.16 6.53 owned Bond B, the higher yield to
6.0 8.11 7.43 6.82 maturity on Bond A might induce

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Office of Thrift Supervision

the manager to swap Bond A for

Bond B in a pure yield pickup swap Table 2. Scenario Analysis for Bond B’s Total Return
transaction. However, Tables 1 and
2 show that the likely returns on Required Yield at End of
both bonds are sensitive to what 3-Year Investment Horizon (%)
happens to interest rates, despite the 6.0 8.0 10.0
higher promised yield to maturity
for Bond A. To see this more clear- Reinvestment Rate (%)
ly, Table 3 shows the total return for 4.0 12.00 7.50 3.48
Bond A minus the total return for 5.0 12.08 7.58 3.57
Bond B in basis points.
6.0 12.16 7.67 3.67
Table 3 shows that for required
yields of 6 and 8 percent, Bond A’s
total return exceeds that of Bond B’s
for all three reinvestment rates. Table 3. Bond A’s Total Return Minus Bond B’s Total Return
However, for a required yield of 10 (in Basis Points)
percent, the situation reverses dra-
Required Yield at End of
matically, with Bond B’s total return
3-Year Investment Horizon (%)
exceeding that of Bond A. These
results suggest that investment deci- 6.0 8.0 10.0
sions based only on stated yield to Reinvestment Rate (%)
maturity will not produce the best
total returns as interest rates change. 4.0 136 28 - 42
The results of this simple example 5.0 137 29 - 41
demonstrate the importance of con- 6.0 137 30 - 41
ducting a stress test over various
interest rate scenarios when evaluat-
ing the expected return on invest-
ment securities prior to taking
positions in these financial instru- portfolio of fixed-income securities, total returns depending on changes
ments. some investors use promised yield in reinvestment rates, end-of-period
to maturity or yield to call as selec- required yields, and length of the
tion criteria. These yield measures, investment horizon. However, there
however, are unlikely to reflect the is an important caveat. In comput-
Conclusion correct expected investment return ing total returns based on scenario
as interest rates change and invest- analysis, investors should be aware
ments are sold prior to maturity. that total return estimates will only
This Risk Management Release has Instead, total return provides a better reflect expected investment returns
shown how total return calculations measure of expected investment if expectations regarding reinvest-
based on scenario analysis can be return. ment rates and end-of-period yields
used to measure the expected return turn out to be correct.
of fixed-income securities. In evalu- In summary, investment decisions
ating the likely return of an individ- made on the basis of YTM or YTC
ual fixed-income security, or can lead to investments with lower

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