The average rate of return of a bond has two components. The coupon stream, usually paid semi-annually, is the source of income. The variation of price in the bond, due primarily to variations in interest rates, is the other. The combination of components is called total return. Average total return can refer to either historical returns or returns by a particular type of bond such as municipal or corporate bonds.
Interest Rates Vary Returns
Investor returns from 10-year treasury bonds since the end of World War II have averaged about 5 percent. During this time rates have ranged as low as 2 percent and as high as 15 percent. The average return is best divided into two periods. When the Federal Reserve Bank is lowering short-term interest rates, all maturities of bonds experience rising capital gains and failing coupon yields. When rates rise, coupon yields rise while bond prices fall.
Maturity and Bond Returns
Money market instruments are due in less than a year. Fixed income notes are due in less than 10 years. Bonds are debt instruments that are due within 30 years, though occasionally bonds will have longer in maturity. Short-term instruments vary more in yield than long-term bonds. However, price volatility is greater in long-term debt because of the greater maturity risk. Average bond yields vary more with short rates. Average bond prices vary more with long maturities.
Average Returns By Currency
One consideration for investors computing average return is which currency to use to measure average returns. Measured in the United States, dollar bond returns have been negative throughout most of the world because the coupon income cannot offset the capital loss due to the falling dollar. In other words, if someone sold German marks to buy U.S. bonds, the value of the bonds and the value of the coupon income has gradually declined as the mark has strengthened.
Bond Ratings Affect Yields
The spread or difference between the highest- and lowest-rated securities varies constantly. This is because in bad economic times, investors become more safety conscious and buy less risky securities while shunning low-rated securities. Thus, while the average yields of both high and low securities rise and fall together, the relative spreads also vary. Credit spreads are regularly used in professional trading.
Average Returns Reflect Survivorship
There are many bond indexes that purport to measure average returns. Average returns can be distorted because some high-quality bonds will have suffered impaired or lowered credit rating. Thus, bond averages over time will not include all the same bonds. It is generally best to discuss only the highest-quality bonds, such as treasury bonds, and then add the credit spread discussed above to reflect different quality yields.