Return Potential For Bonds

Looking at the U.S. treasury bond rates over the last ten years, the long term return potential for bonds is around 3%. When inflation is considered, this drops your return on real buying power virtually to zero.

While bonds can be quite complicated, we will look at a typical bond structure. It turns out that the only numbers needed to calculate the long term return are the coupon rate (or interest rate) and the maturity date.

If you’re interested in comparing return rates between different types of investments, check out these other articles:

U.S. dollar bill showing the U.S. treasure label

What Is A Bond?

A bond is a loan given to a company or government by an individual. When you buy a bond, you are actually loaning your money with the expectation that it will be paid back with interest.

One important thing to know about bonds is they pay out at regular intervals. And how much they pay is based upon the bond’s coupon rate.

If you purchase a bond for $1,000 with a coupon rate of 4%, then you will be paid $40 each year (4% of the $1,000).

The coupon rate is the most important part of determining a bond’s return potential.

Another important number is the maturity date.

These payouts continue until an agreed upon date. That date is called the maturity date. On the maturity date the original amount is paid back to the user. In the example above you would get your $1,000 back on the maturity date.

Both coupon rate and the maturity date are needed to calculate the long term return of a bond. So let’s get to it!

Return Potential for Bonds Ignoring Inflation

To start with let’s look at a very simple example.

5% coupon rate and 1 year maturity date

You purchase a $1,000 bond with a 5% coupon rate and a maturity date in 1 year.

So in this example you receive a $50 payout during the year and get your $1,000 back at the end of the year.

That’s $1,050 after 1 year on your $1,000 investment, which is a 5% return on investment.

So the return is exactly the coupon rate in this example, but let’s look at an example where that’s not the case.

5% coupon rate and 5 year maturity date

You purchase a $1,000 bond with a 5% coupon rate and a maturity date in 5 years. You might expect the return to be 5% again, but we’ll see that’s not the case.

Using an investment calculator we see that a 5% return on $1,000 over 5 years should yield a total value of $1,276.

What happens with the bond?

Well we get $50 the first year, then $50 the second year, and $50 the third, fourth and fifth years, too.

After getting our $1,000 back it brings the total to $1,250. That actually puts our five year return at just under 4.6%.

5% coupon rate and 10 year maturity date

One more $1,000 bond example to prove the point. If we look at the investment calculator again, we would expect a 5% return over 10 years to have a total value of $1,629.

It should be pretty clear now we’ll get ten $50 payouts, totaling $500.

When we get our $1,000 back it all adds up to $1,500. This time it’s a ten year return of only 4.1%!

Return Potential For Bonds Including Inflation

Before we look at what’s going on here, let’s briefly discuss how inflation will affect returns.

Inflation changes from year to year, but the average rate of inflation over the last 100 years or so is about 3%.

Inflation helps measure the buying power of the money we have, so to know how our buying power increases over time, we must subtract the inflation rate from our return.

So the inflation inclusive return from our 1 year maturity date would be 3%.

Five year maturity date return would be 1.6%.

And ten year maturity date return would be 1.1%.

Reasons For Lower Returns

Now let’s talk about why the return rate is affected so much by the length of the maturity date.

Coupon rate vs. long term return

The coupon rate is simply the percentage of your bond value that is being paid out each year.

When we look at long term return of an investment we consider compounding interest. We want our return from this year to produce additional return next year.

The setup of the bond agreement does not allow for compound interest. If it did, we would expect our payout in year 2 to be bigger than the payout in year 1.

Lacking compound interest

Let’s compare the 5% coupon rate bond to an imaginary investment that gets 5% long term.

Our bond is purchased for $1,000 and the payouts are calculated as 5% of that $1,000 value. For as long as you hold the bond it will continue to earn 5% of the original $1,000 value. The total bond value will look like this.

$1,050 ($1,000 + 0.05 x $1,000)
$1,100 ($1,050 + 0.05 x $1,000)
$1,150 ($1,100 + 0.05 x $1,000)
$1,200 ($1,150 + 0.05 x $1,000)

And this pattern will continue until the maturity date.

An investment that gets a 5% long term return is able to leverage the interest accrued to bring in more value each year. The investment’s total value would look like this.

$1,050.00 ($1,000 x 1.05)
$1,102.50 ($1,050 x 1.05)
$1,157.63 ($1,102.50 x 1.05)
$1,215.51 ($1,157.63 x 1.05)

And this pattern continues.

If you look at years 1 and 2 in both of these examples you’ll notice that the long term 5% investment gets 5% return on the $50 earned in the first year, while the bond earns no interest on the $50 payout.

How to make long term the return equal the coupon rate

There are ways to get a return on those payouts and prevent that slow decay of returns over time.

Reinvest the payouts!

If you get your $50 payout and immediately purchase a bond with a 5% coupon rate, then you will get a 5% return on that payout.

The other way to potentially outperform your coupon rate is to engage in the buying and selling of bonds before their maturity date.

Since the coupon rates of bonds can change from year to year, you may see a 5% coupon rate this year and a 6% coupon rate next year.

You can sell your existing bond for close to the $1,000 face value of the bond and use all your proceeds to purchase a new 6% bond.

In the end, if you want to maximize your return, you just need to make sure you’re reinvesting your payouts.

Taxes on Bond Payouts

If you want the full picture of the return potential on bonds, you must consider taxes.

The complete rules on bond taxation are somewhat complicated. It will suffice for this article to consider only the taxation of the payouts.

Payouts on government issued bonds are taxed as income at the federal level, but are exempt from state and local taxes. And corporate bonds are taxed just like regular income.

This means that the best case scenario for a bond is you’re taking home only about 70-80% of your payouts.

All of the sudden your 5% return becomes a 4% return!

Bringing It All Together

We’ve seen how bonds work and we know enough now to give an estimate on their return potential.

If we reinvest our payouts, then our pretax potential is limited by the coupon rate on the bond.

The coupon rate on government treasury bonds over the last 10 years have been slowly falling from about 4% to below 2% in recent years.

So our expected return on bonds is about 3%, with the potential to increase slightly over time.

When you consider inflation in the mix, your increase in buying power basically goes to zero.

Conclusion

While bonds are usually called a safe investment, right now they are not much better than putting your money in a high yield savings account.

If you’ve already accumulated your wealth and you want a very passive investment that will ensure that wealth keeps pace with inflation, then bonds are probably a reasonable investment.

However, if you’re looking to grow your wealth over time there are much better options.

Happy investing.

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