TOTAL RETURN: Don’t Focus Solely on Price Change

Dollar up downHumans, especially those of us “number people”, are wired to focus on price change. And when it comes to investments, price change is certainly a gauge of how an investment is doing. But is it the only factor? Absolutely not.

Price change is just one-half of the components that dictates total return. Here’s the formula you need to know when it comes to performance:

TOTAL RETURNPRICE CHANGE + YIELD

What this means is that Total Return equals not only the return on investment due to price appreciation/ depreciation but also due to reinvested dividends or income. Frankly, price change alone can be a really poor gauge of how an investment is doing particularly one with regular distributions such as bonds. So, let’s talk about bonds.

We’ve discussed the inverse relationship between rising interest rates and bond prices before. Assuming the economy continues to heal and rates continue to rise, bond prices will go down on paper. In that case:

?

=

+

?

TOTAL RETURN

=

PRICE CHANGE

+

YIELD

We still don’t know what that does to total return. But let’s say we have a bond yielding 6% then we know:

?

=

-?

+

+6

TOTAL RETURN

=

PRICE CHANGE

+

YIELD

If the yield is bigger than the price change, then total return is still positive. As I mentioned in my last quarterly market commentary, a bond typically will lose 1% in price for every year of duration that it has left for every percentage point rise in interest rates. Hence, let’s assume a one-year time frame and if interest rates go up 1% for a fund that has 4 years of duration (meaning time to maturity) with a 6% coupon, then we know:

+1

=

-5

+

+6

TOTAL RETURN

=

PRICE CHANGE

+

YIELD

Even though the price went down 5%, the total return on the investment was actually up because of the positive-ness of the investment’s yield.

So don’t get caught up in just one part of the formula, folks. Total return is what matters.

BTW, this doesn’t only apply to just bonds. Yield (in the form of dividends) make a difference to equities as well.

Did you know that the S&P 500 has gained +9.8% per year over the last 50 years (1963-2012) on a total return basis? If you remove the impact of reinvested dividends, the raw index is only up +6.4% annually, HENCE dividends make up 35% of the index’s total return in the last half century. Wow!

(source: BTN Research)

Gentlemen Prefer Bunds (German Bonds)

On March 10th, U.S. stocks declined for a fifth day.  The reason most often given was concern over Europe. Bond prices on most European bonds have declined, producing higher yields. Investors have flocked to safe havens, such as U.S. and German bonds, pushing those prices up and those yields sharply lower.

Spain’s ten year bonds are now yielding 5.8%. Spain is entering its second recession in three years, unemployment is at 23% and the government expects the economy to contract about 1.7% in 2012. The Spanish stock market is the lowest since March 2009. The concern is that austerity measures could have the effect of further depressing growth and creating a vicious cycle in which more budget cuts are needed to balance the books. Italy’s ten year bonds are not far behind, yielding 5.5%.

French business confidence has stagnated and factory output has dropped. Manufacturing production fell 1.2% in February and the Bank of France said its surveys suggest that GDP didn’t expand in the first quarter. On March 31st the Economist characterized France, Europe’s second largest economy, as “A Country in Denial.” Comparing them with Greece, the Economist indicated that “the Greeks know that free-spending and tax-dodging are over. But (France) has yet to face up to its changed circumstances.” Upcoming French elections demonstrate the reluctance to change. Front-runner Socialist Francois Hollande has promised to rollback most of the recent pension-age reforms and install a 75% tax rate on the wealthy. None of the candidates are offering radical reforms or austerity programs seen in other European elections recently. Yields on France ten-year bonds are currently 2.93%. But that could move up quickly and significantly right after the elections.

Germany is the one major bright spot. German ten year bonds are yielding 1.8% (as compared to ten year US treasuries yielding 2.04%.) Germany’s exports are up and its trade surplus surged in February. The above chart tells it all. German productivity has far outpaced the rest of Europe in the last eight years. Nominal unit labor costs have stayed almost level in Germany, while growing in Italy, Ireland, Spain, Greece and France. During this period, only Ireland has seen their costs drop, starting in 2008, as their labor accepted pay cuts and productivity increased. To get on par with Germany, all five countries would need a 30% pay cut to become competitive. It’s unlikely we can expect that to happen any time soon.