It may be difficult to determine which investment alternatives are performing well and which have underperformed when there are so many available.
To track the performance of your assets, you may employ the realized return formula, which accounts for the complete amount of gain or loss suffered from keeping the investment.
Knowing the performance of your assets enables you to make more informed decisions moving ahead.
What is a Realized Return?
The realized return on an investment is the actual return achieved throughout the holding term. This may consist of dividends, interest payments, and other financial distributions.
The word “realized return” can be used to describe a bond sold before to its maturity date or a dividend-paying investment.
In general, the realized return on bonds comprises coupon payments received over the holding term, plus or minus the yearly change in the value of the initial investment.
Understanding Realized Return
Under the majority of conditions, the realized return on assets with maturity dates will differ from the stated return to maturity (YTM). One exception is when a bond is bought and sold at face value, which is also its redemption price at maturity.
For instance, a bond with a 5 percent coupon that is acquired and sold at face value yields a realized return of 5 percent for the holding term. When the identical bond is repaid at face value at maturity, the yield to maturity is 5%.
In all other situations, realized returns are computed based on payments received and the change in value of the principle relative to the amount invested.
What a bond market participant really receives, which is not necessarily the advertised return to maturity, is the realized return. Given similar credit quality, a one-year bond with a 3 percent yield and a principle of $100 selling at $102 is nearly equivalent to a one-year bond with a 1 percent coupon selling at par.
We describe this equivalence by noting that the yield to maturity on both of these bonds is around 1 percent. Suppose, however, that a month later, the market interest rate decreases by 0.5 percentage points, causing the price of one-year bonds to increase by approximately 0.5%.
If the investor sells the bonds after only one month without receiving any coupon payments, he or she will earn a return of little more than 6 percent each year.
Additionally, realized return is a very valuable notion for analyzing high-return bonds. Realized return provides investors with a method of coping with the reality that some high-return bonds virtually inevitably default.
Due to defaults, a high-yield bond fund’s actual return is likely to be lower than its return to maturity.
An illustration will aid in elucidating how realized return functions in the high-return bond market. Assume that interest rates and total default risk do not change throughout a given year.
In that year, one-year Treasurys give a yield to maturity of 0.5%. Similarly, a high-return bond fund provides a return to maturity of 5%, but 3% of bonds default annually.
Due to defaults, the realized return on the high-yield bond fund was just 2%, but the return to maturity was 5%. On the other hand, the realized return for Treasuries was 0.5%, which was the same as their return to maturity.
Realized Yield vs. Realized Return
Realized yield, like realized return, is simply the amount of money that the investor actually earned. The words “realized yield” and “realized return” are sometimes used interchangeably in the bond market.
On the stock market, however, the phrase “realized return” is more commonly employed than “realized yield.” High dividend yielding equities are a significant exception.
Types of Realized Return
Realized return is the overall return realized when an investor sells a bond before to its maturity. Bonds maturing in three years with a 3 percent yield and a face value of $1,000 have a 3 percent return to maturity, for instance. If the bond is sold exactly one year after purchase for $960, the principal loss is four percent.
The 3 percent coupon payment reduces the realized return to -1 percent. Instead, say that the bond is sold a year later at $1,020 for a gain of 2% in principle. The 3 percent coupon payment boosts the realized return to 5% in this instance.
Early CD Withdrawal
Depositary certificate Investors that cash out prior to the maturity date are frequently subject to a penalty. On a two-year CD, the standard early withdrawal penalty is six months’ worth of interest. For instance, an investor who redeems a two-year CD that pays 1 percent after one year would accrue $1,000 in interest.
Six months of imprisonment corresponds to a $500 fine. After paying this charge, the investor receives $500 over the course of one year for a realized return of 0.5%.
The computation for realized return applies to exchange-traded funds (ETFs) and other investments without maturity dates.
For instance, an investor who keeps a 4-percent-yielding ETF for exactly two years and then sells for a 2-percent profit would have earned 4-percent annual interest.
The increase in principle is amortized over a two-year holding period, resulting in a 1 percent annual gain and a 5 percent annualized return.
How to Calculate Realized Return
Calculate Realized Return
The return on an investment is comprised of two components: the price appreciation or depreciation of the investment, and any income received while holding the investment.
For instance, a stock may pay quarterly dividends to its shareholders, while a bond may pay quarterly interest. You might be undervaluing the performance of your dividend-paying stocks or income-producing bonds if you exclude the income component.
To determine the realized return, compute the increase or decrease in the value of the investment by subtracting the starting price from the final price. Then, include any revenue received while you owned the investment.
For example, suppose you purchased a stock for $50 at the beginning of the year and sold it at the end of the year for $49, but it paid $1 in dividends every quarter. Subtracting the initial price of $50 from the final price of $49 reveals a loss of $1 in value.
However, when dividends of $4 are included in, the actual return on the investment is determined to be $3. If you neglected the income component, you would have erroneously concluded that the investment resulted in a loss.
Realized Return as a Percentage
Calculating your realized return as a dollar amount is beneficial, but it prevents you from comparing the relative performance of investments of various sizes. For instance, a $500 return may seem wonderful, but it would be much more attractive if you just had to invest $1,000 rather than $100,000.
Divide the amount of your realized return by your initial investment to determine your realized return as a percentage. To convert the decimal to a percentage, multiply the value by 100. In the case of a $3 return on a $50 investment, divide $3 by $50 to get 0.06. Then multiply 0.06 by 100 to determine that you earned a 6 percent return on your investment.
Realized return is the real return achieved on an investment throughout the holding period, which may include dividends, interest payments, and other cash distributions.
Under the majority of conditions, the realized return on investments with maturity dates will differ from the stated return to maturity.
It is typical in the bond market to use “realized yield” and “realized return” interchangeably.
The word “realized return” is applied to bonds, certificates of deposit, and fixed-income mutual funds, whereas “return on investment” is the preferred term for stocks.
- What Is a Commissions Expense? Definition, Overview, 8 Facts - September 17, 2022
- What are the Different Types of MLM Businesses? 5 Facts - September 17, 2022
- What Is Business Process Change? 7 Facts You Need To Know - September 16, 2022