The United States has the largest bond market globally, valued at over $51 trillion as of 2022, according to data from Visual Capitalist. The federal government is the chief issuer of fixed income securities, with Treasuries representing roughly 40% of the U.S. bond market.
For many investors, the appeal of bonds comes from their relatively predictable income stream and the security of their principal investment. One common misconception, however, is that the return on a bond is limited solely to its coupon rate.
In addition to income, bonds can offer meaningful appreciation potential depending on the timing of your purchase. By breaking down the components of a bond’s total return, you can gain a clearer understanding of how this asset class fits into your overall investment strategy.
Table of Contents
Understanding Bonds
A bond represents a loan made by an investor to a borrower, such as a corporation or government. In return for the loan, the borrower agrees to pay the investor periodic interest payments (the coupon), until the bond matures. At maturity, the borrower returns the bond’s face value (the principal) to the investor.
Investors generally classify bonds by sector, credit rating, and maturity. Each classification offers insights into a bond’s behavior and potential risk-reward profile.
- Sector. This describes the issuer of the bond, such as a government, agency, or corporation. Each sector has unique risk and reward characteristics.
- Maturity. This refers to the length of time until an investor receives the bond’s principal. Bonds can be short-term (maturing in less than 3 years), intermediate-term (3-10 years), or long-term (more than 10 years). In general, the longer the maturity, the more sensitive the bond is to interest rate changes.
- Credit Rating: Agencies like Moody’s, S&P, and Fitch provide credit ratings for bonds, which reflect the issuer’s ability to pay back the debt. Bonds with higher ratings (AAA to BBB or equivalent), also known as investment grade bonds, are relatively safer than bonds rated BB and below. These bonds, sometimes referred to as high-yield or junk bonds, come with higher risks but also potentially higher yields.
Interest Rates & Bond Prices
An essential concept in the world of bonds is the inverse relationship between bond prices and interest rates. This relationship is fundamental to understanding bond price fluctuations in the open market.
When interest rates rise, new bonds are issued at higher rates, making them more attractive to investors since they yield a better return than older, lower-yielding bonds. As a result, the demand for older bonds decreases, causing their prices to fall.
Conversely, when interest rates drop, new bonds are issued at lower rates. Demand for older bonds, which yield a higher return in comparison, increases, causing their prices to rise.
In other words, the prevailing interest rate environment often influences whether bonds sell at a discount or premium relative to their face value. When interest rates are on the rise, as they have been since March of 2022, investors may find more opportunities to purchase bonds at a discount. We’ll explore why this can be an advantage in the remainder of this blog post.
Coupon Rate vs. Total Return
A bond’s coupon rate is the fixed annual rate that it pays its holder or owner. It’s based on the face value (or par value) of the bond at the time of issue. So, if a bond with a face value of $100 has a 5% coupon rate, its bondholder receives $5 each year in income.
It’s not uncommon for investors to view the coupon rate as their sole source of return from a bond. If a bond pays a 5% coupon, for instance, they expect a 5% annual return on their investment.
However, the total return on a bond can be influenced by several factors, including:
- Purchase Price vs. Face Value. Since there’s a secondary market where investors can freely trade bonds, it’s possible to purchase a bond at par, at a discount, or at a premium. Par means you’re buying the bond at its face value, say $100, while a discount means you’re purchasing the bond for less than its face value, say at $98. Meanwhile, a premium means you’re paying more than face value.
- Maturity and Capital Appreciation. Bonds mature at face value. Therefore, if you buy a bond at a discount, you’ll realize a capital gain at maturity. For example, if you purchase a bond at $98 and it matures at $100, you gain an extra $2 on top of the coupon payments—a difference that can meaningfully boost your total return.
- Interest on Interest. If you purchase a bond and reinvest the coupon payments as you receive them, you’ll enhance your overall return due to the power of compounding (i.e., earning interest on interest).
Thus, a bond’s coupon rate only reflects the annual income you receive. However, total return tends to be a more relevant measure of performance due to the potential for capital appreciation.
Calculating a Bond’s Total Return
Conceptually, you can think of a bond’s total return as the combination of the income and growth it generates over your holding period. Let’s look at a simplified example of how this works in practice.
Suppose you buy a Treasury bond for $98 on the open market. It has a 5% annual coupon and matures in one year at $100. Here’s how the total return breaks down:
- Coupon Payment: 5% of $100 = $5
- Capital Gain at Maturity: $100 – $98 = $2
At the end of your one-year holding period, your total return is $7, or 7.14% of your initial investment of $98. Clearly, this is a higher rate of return than the 5% coupon implies.
The Value of Expert Guidance
Like stocks, bond prices tend to fluctuate over time—although generally not as dramatically. Still, these fluctuations can present attractive buying and selling opportunities for savvy investors.
Ultimately, buying bonds at a discount can provide a significant boost to your total return potential. When this is the case, it’s often beneficial to look beyond the coupon rate and instead consider the total return opportunity.
Fortunately, you don’t need to track the market to take advantage of investment opportunities as they arise. By working with a fee-only financial advisor like Milestone Asset Management Group, you can benefit from our expert resources, including ongoing investment management and portfolio oversight.
Our team of experienced financial professionals can help you design a personalized investment plan tailored to your financial needs and objectives. Contact us today to discover how we can support you in safeguarding and growing your hard-earned wealth, guiding you toward to your financial goals.
