Return of Principal Versus Return on Principal
Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
Individual bonds help preserve your principal in a way that many other product types can’t. The protective characteristic is an individual bond’s stated maturity. We have been mesmerized for decades by total returns afforded nearly all product types, including total returns that bonds have enjoyed to the degree that perhaps we’ve lost realistic methods of bond assessment and purpose.
First, what is total return? Total return measures the actual rate of return over a period of time. It includes interest/dividends, capital gains, and distributions realized. The capital gain is typically the important component for successful returns in stocks for example. If you purchase stock “X” at $50/share, the desire is to sell this stock at an elevated market price. Your return is dependent on this capital gain. Many growth assets rely upon or need quality capital gains for their return. Although the risk exists that the price remains flat or drops, the upside can be the source of quality growth of your assets.
Individual bonds play a much different role in the portfolio. One might say that investors have been a little spoiled by total returns experienced by individual bonds over the years; however, bonds' real purpose, for many investors, is to preserve the hard-earned growth or wealth.
This is accomplished by the fixed nature of individual bonds and the feature of a stated maturity. Once a bond is purchased, the cash flow, income and date that the face value is returned is locked in. No matter what happens, including supply/demand changes or interest rate movements, an individual bond’s performance is locked barring a few events. If you sell a bond before its maturity, that bond would be subject to market conditions (it might be at a loss or profit depending on the market). The other is that the bond defaults. This possible risk is often mitigated by purchasing high quality credits that are financially sound and highly rated.
Individual bonds held to maturity provide known results. Without the maturity date, there is never a pledged point in time when an investor is secure in receiving their initial investment back. Appropriate asset allocation combines growth (return on principal) and wealth preservation (return of principal) in any market.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
Stocks are appropriate for investors who have a more aggressive investment objective, since they fluctuate in value and involve risks including the possible loss of capital. Dividends will fluctuate and are not guaranteed. Prior to making an investment decision, please consult with your financial advisor about your individual situation.