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Step 1
Define the period for the bond performance to be calculated. It can be any period from one day to the entire bond maturity. Compute the price difference of the bond for the beginning and at the end date. For example, the 1 year principal return for a bond at the beginning of the year priced at par (100) and closes on the last day of the year at 102 is a 2 divided by 100, or 2 percent return.
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Step 2
Compute the interest that was accrued during the time frame. All treasury bonds use a 30/360 pricing formula. This means, for purposes of calculation, every month is assumed to be 30 days long. Leap year is ignored. Thus a 6 percent bond pays 1/2 percent interest a month.
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Step 3
Add the total of the interest earned plus the change in the bond's principal amount to compute the total return. In the above case, a 6 percent interest rate and 2 percent capital appreciation results in a 8 percent total return.
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Step 4
Performance of bonds is greatly affected by any call feature. A call feature is the right of the issuer, in this case the U.S. Government , to redeem outstanding bonds at a date specified at the time of issuance at a price (usually par). Government notes and bonds exceeding 10 years usually have a 10 year call feature. Presume a 30 year bond with a 6% coupon trades at a yield of 5.75 percent. The dollar price of the bond is approximately 101.25 not the 102.5 a 30 year bond non-callable bond should bring. For one year then the total return is 7.25% not 8.5%.
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Step 5
Savvy traders buy discount bonds when expecting an extended rally. Because the bonds are priced less than par they have further to appreciate in price because of the lack of call feature. The result is that total return is more from capital appreciation and less from the smaller coupon that makes the bond trade at a discount in the first place.
