Yield and total return are concepts SMI has historically discussed in relation to bonds or other savings vehicles. But because our Dynamic Asset Allocation (DAA) strategy recently presented a scenario involving these factors that confused a number of readers, it is an opportune time to revisit these subjects in a wider context.

There’s some math in this article. If you aren’t math savvy, you’ll be glad to know that it’s not essential you understand these two terms in order to make investments when following SMI’s strategies. They come into play primarily when you attempt to measure the results from your investments.

Let’s start with a quick review of the basics before widening the lens. To learn whether a particular savings-type or bond investment has been successful, ask two questions: First, how much interest income did you earn while waiting to get your money back? Second, did you get all of your original investment back, more than you put in, or less?

The income you received while your money was tied up is called the yield. It’s always expressed in “annualized” terms (i.e., what the investment pays over one year). Example: If you invested $1,000 in a 10-year bond and it paid $30 a year in interest, it yielded 3.0% per year ($30 ÷ $1,000).

With a bond (or bond fund), however, the yield is only one aspect of how well the investment performs. Let’s say interest rates fell after you made your $1,000 investment. When rates fall, bond prices rise. As a result, you may have been able to sell your still un-matured bond after three years for a profit — say for $1,050. This would give you a $50 capital gain. When you combine your yield and your gain, the result is your total return.

In our example, you invested $1,000 and received back $1,140 over three years ($90 in interest income plus the $50 gain). To gauge your total return in annual percentage terms, you need to figure out what rate of growth would turn $1,000 into $1,140 in three years. A financial calculator that performs time-value-of-money computations will show that it takes a 4.46% annual rate of return to do that. In other words, if you could invest $1,000 at 4.46% for three years (compounded annually), you would have about $1,140 at the end of that time.

How did you get from a yield of 3.0% to a total return of 4.46% — almost 1.5 times better than the stated yield? By selling your bond investment for a $50 gain. The 3.0% yield you received as you went along plus the $50 gain at the end combined to produce a 4.46% annualized total return, significantly better than the promised yield alone.

But suppose interest rates had risen and the bond’s price had gone down by $50 and you sold at a loss? That would have created a much different result. After three years, you would have $1,040 to show for your $1,000 investment ($90 in interest income minus a $50 loss). While you thought you were earning 3.0% a year, it turns out you were actually netting, on average, just 1.32% per year. So yield tells only part of the story. Total return is what you’re really interested in.

This information helps you understand why not all savings vehicles are interchangeable. Some fixed-income investments — e.g., insured savings accounts, CDs, and money-market funds/accounts — do not fluctuate in value. You’ll always be repaid what you put in, plus any interest you earned; there is never a loss of your original capital to worry about. However, other fixed-income investments, such as bond funds, do fluctuate in value. When you eventually sell, you’re likely to get back more or less than you put in. In some situations, you could lose more on the sale than you received in interest. The unhappy result would be a negative total return.

So for your emergency money, it’s better to stick with money-market funds or bank money-market accounts that aren’t subject to daily changes in value. For your accumulation fund, it’s OK to go for the higher returns available from bond funds. But to minimize the risk of negative returns, be sure to match your expected investment time frame to the right kind of fund.

For example, if you know you won’t need your savings for two-to-three years, consider a short-term bond fund. The bonds held by such funds offer higher yields than shorter-term instruments, and those higher yields typically compensate for any temporary minor losses in value due to changes in interest rates.

For periods of three years or longer, you might look into mortgage-backed bond funds. These funds, often referred to as GNMA (Ginnie Mae) funds, invest in mortgage-backed securities issued by the Government National Mortgage Association. Ginnie Maes are even more sensitive to interest-rate changes than are short-term bonds, so a longer holding period is crucial. In the past, the higher yields of Ginnie Maes have more than offset (eventually) short-term losses caused by rising interest rates.

Moving from the savings arena into the investing sphere

Thankfully, it’s just a short jump to apply these same concepts to investments that fluctuate more significantly in value. For instance, when our DAA strategy calls for owning long-term bonds, the application of yield and total return is exactly the same as just described for short-term bond funds. The difference is simply a matter of degree — long-term bonds will respond more dramatically, for better or worse, to changes in interest rates. Whereas a short-term bond fund’s total return will normally be comprised primarily of its income (yield) with a small capital gain/loss component, the primary driver of a long-term bond fund’s total return will often be the capital gain/loss element by itself. When interest rates are on the move, this capital-gain piece can easily overwhelm the income earned by long-term bonds.

While bonds and savings vehicles are the most obvious investments to focus on when discussing yields and total returns, other investments are also affected by this same dynamic. For example, some stocks pay dividends, and this “dividend yield” factors into the total-return calculation in the same way that a bond’s yield from interest income does.

When DAA recently sold its Real Estate holding (VNQ), some readers were perplexed at the reported returns. In most of these cases, the confusion stemmed from simply looking at the price at which they had bought VNQ and comparing it to the price they sold for. This approach computed a significantly smaller gain than SMI was reporting. The missing variable in the equation was the significant amount of income that had been paid out to VNQ shareholders during the 16 months it was owned.

Here’s how the specific numbers broke down. Using the final month-end prices from when VNQ was first recommended and then later sold, readers would have bought at around $70.73/share and sold at around $74.69/share. That represents a 5.6% gain, which was only about half as much as the 11.6% gain SMI reported in the sell announcement on June 30. No wonder some readers were confused!

In this particular case, the $3.96 change in price (the capital gain) was actually overshadowed by the $4.193/share in income distributions an investor would have received from VNQ during the prior 16 months. Only by adding the capital-gain and income-distribution amounts together (and then dividing by the starting price) would an investor arrive at the correct total return.

Three of DAA’s asset classes (Bonds, Cash, Real Estate) derive a substantial proportion of their total returns from periodic income distributions, so it’s helpful to understand how both yield and capital gain/loss work together to generate total return. Years ago, the same used to be true of many stock investments, though in recent decades yield has largely been an afterthought for growth-oriented stock investors.

The easiest way for investors to deal with this potentially confusing situation is simply to rely on data sources that report total returns in the first place. SMI typically reports all performance numbers in total return terms, as does our primary data source, Morningstar. Most brokerages should also report total returns (although not all do and the way returns are reported at some brokers can be confusing). The main thing to avoid is looking only at the beginning and ending prices and forgetting to account for income distributions. Now that you know to be on the lookout for the two factors that can affect your total return, you should be able to navigate these potentially confusing waters with ease.