The Importance of Total Return

I have always believed that total return is the best measurement tool for evaluating overall bank bond portfolio performance.

While the income derived from coupon payments is of course a key reason why we own bonds, the market value of your bonds is equally important.

Total return can be simply defined as the yield from all the coupon income investors receive plus the gain or loss (as a percentage) in market value of a bond (or portfolio). While it is easy to purchase bonds that create higher current income through longer maturities, more call option risk, or are illiquid or possess weaker underlying credit quality, total return is a more difficult and important benchmark for which to target.

I have always called total return, the great equalizer.

The market value of your bond portfolio changes every day with the direction of bond prices in the market. Each month, banks are required to revalue (or mark to market) each of their bonds so that the current gain or loss can be calculated and included in your market value of equity, frequently called MVE.

If you ever sell your bank or wish to purchase another, you will want your MVE to be as high as possible. If your bank’s stock trades on a stock exchange like NASDAQ, your MVE is very important.

This is the bottom-line reason for always managing total return instead of simply attempting to achieve the highest current income (yield) possible from your bank’s bond portfolio.

Two related mathematical concepts contribute greatly to a bond portfolio’s total return: duration and convexity.

We will manage both in concert.

Duration can be defined simply as the percentage price sensitivity change of a portfolio when interest rates move 1 percent in either direction.

Convexity, the first derivative of duration, measures the ability of a bond to hold its market value in a uniform interest rate shock up and down. Our goal will be to have the rate shock portfolio market values be as symmetrical as possible.

Both concepts will be critical in my process of protecting bank capital, or market value of equity.