The concept of return on investment is fundamental to money management. By comparing what you put in versus what you get back, you can easily compare performance across your portfolio. There are several ways to measure your return and we'll use U.S. Treasury bonds as an example for our calculations. They're considered one of the safest investments because they're backed by the full faith and credit of the U.S. government. These bonds can be purchased directly from the Treasury during its regular auctions or on the secondary market.
The first component of a Treasury bond's return is its capital appreciation or depreciation. Treasury bonds are actively traded on the secondary market and their price fluctuates daily. Say that you buy a 30-year Treasury bond issued on February 15, 2013, and maturing on February 15, 2033. You pay a purchase price of $98.00. Now let's say that you you hold the bond for exactly one year and sell it on the secondary market on February 15, 2014 for $99.96. From capital appreciation alone you'd have realized gain of $1.96, an annualized investment return of 2 percent.
The second component of a Treasury bond's return is compound interest. Treasury bonds pay interest semi-annually based on a stated rate called a coupon rate. Say that the coupon rate on the 30-year Treasury bond example discussed earlier is 5 percent. That means that for every $100 of bonds investors receive $2.50 every six months, an annual return of $5. However, the compound return is actually sightly higher than the coupon rate because investors can re-invest the $2.50 received in the first six months and earn $2.625 ($2.50 x 1.05) over the course of the year on that payout. Adding this amount to the $2.50 owed to them at the end of the 12 months, investors earn a total of $5.125. Therefore, the annualized investment return from compounded interest payments is 5.125 percent. If we sum up the return from capital appreciation (2 percent) with the return from interest and compounding (5.125 percent), we find that the Treasury bond's total return was 7.125 percent.
Some investors may be interested in real returns, or returns that are adjusted for inflation. Say that inflation in our earlier example is 2.5 percent per year. To calculate the Treasury bond's real return we would subtract the rate of inflation from the total return: 7.125 - 2.5 = 4.625 percent. Bond investors are especially interested in real returns because bonds don't always keep up well with inflation. It's even possible for bond investors to earn negative returns if inflation is rising quickly enough and exceeds the rate of return.
Finally, you may wish to calculate an after-tax return. Interest payments for fixed income investments like Treasury bonds are usually taxed as ordinary income while capital appreciation is taxed as a capital gain. Say that your marginal tax bracket is 30 percent and the capital gains tax rate is 20 percent. If you invested $10,000 in our earlier example, this would result in interest income of $512.50 ($10,000 x 5.125 percent) and a capital gain of $2,000 ($10,000 x 2 percent). You would owe ordinary income tax of $153.75 ($512.50 x 30 percent) and a capital gain tax of $400 ($2,000 x 20 percent) for a total of $553.75. Your total return of 7.125 percent would have to reduced by this amount.
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