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Bond Return Calculation Methodology

Morningstar Methodology Paper
June 30, 2013
©2013 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc.
Reproduction or transcription by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited.

Content Introduction Coupon Payment and Accrued Interest 3 5 Coupon Dates Coupon Payment Amount and Accrued Interest Actual/Actual Day-Count Convention Actual/365 Day-Count Convention 5 6 7 8 Actual/360 Day-Count Convention 30/360 Day-Count Convention Bond Total Return Daily Total Return Daily Total Return Index 9 10 12 12 13 Morningstar Bond Return Calculation Methodology | June 30. 2 . Inc. is prohibited. without the prior written consent of Morningstar. 2013 © 2013 Morningstar. Inc. The information in this document is the property of Morningstar. in whole or part. Reproduction or transcription by any means. Inc. All rights reserved..

for the purpose of calculating the daily returns of bonds. For example. and asset-backed bonds. The information in this document is the property of Morningstar. The principal. the buyer pays the seller the agreed-upon price. or issuer. The borrowing entity promises to pay a specified sum of money at specific future dates. Inc. Fixed-rate bonds pay periodic coupons that are constant over the bond's life. commercial mortgage-backed. the interest payment is called a coupon. The clean price plus accrued interest is called the "dirty" price.. Morningstar uses the evaluated price. For a bond. Inc. this is called accrued interest. 3 . is also called the face value or par value. Upon transaction. for the bond plus accrued interest. which is the theoretical fair price of a bond obtained from third-party providers. Zerocoupon bonds do not pay periodic interest and are issued at a discount to par value. and so on. Bonds do not transact every day. aka the "clean" price.Introduction A bond is a debt instrument. This methodology document addresses the return calculation of fixed-rate and zero-coupon bonds. a bond buyer must pay the seller for the amount of interest earned by the latter since the previous coupon date. Since bond issuers do not distribute coupon payments on a daily basis. Therefore. All rights reserved. has an obligation to pay interest at a fixed rate twice a year and repay the principal upon the date of maturity. the borrower. bonds that need principal factors such as mortgage-backed. The methodology does not currently address other types of bonds such as floating-rate notes. the amount that the borrower must repay to the lender. 2013 © 2013 Morningstar. so market price is not always observable. Morningstar Bond Return Calculation Methodology | June 30. Reproduction or transcription by any means. in whole or part. The coupon rate is the interest rate expressed in percentage of principal. The promised payment consists of two components: interest and principal. is prohibited. Treasury Inflation-Protected Securities. Inc. without the prior written consent of Morningstar.

Introduction (continued) In order to calculate a bond's return. × The first coupon date and the maturity date are both unavailable. coupon rate. Reproduction or transcription by any means. This indicates whether all coupon payment dates fall on the last day of the month. 1=annually. Please refer to the Day-Count Convention sections of this document for details. 30 if it is not. Morningstar stops further updates to a stream of returns under the following conditions: × The bond is missing more than five consecutive days of clean price. the return series for this bond restarts from that day onward. which is the theoretical fair price of a bond obtained from third-party providers. and the bond is not a zero-coupon bond. For example. without the prior written consent of Morningstar. the next coupon is paid on Dec. All rights reserved. expressed as a percentage of par value. × Day-count convention: the bond's day-count convention for coupon payments and accrued interest calculation. Inc. Inc. delisting. or indefinite suspension. × Default. 2013 © 2013 Morningstar. If the issuer emerges from default or bankruptcy at a future date. issuer files for bankruptcy protection. 4=quarterly. Morningstar Bond Return Calculation Methodology | June 30. × Clean price: price of the bond without accrued interest. × Coupon rate: annual coupon rate of the bond. 31 if the bond is EOM and Dec. is prohibited. as we would be unable to determine when coupon payments ought to occur. × Maturity date: date the bond issuer must return the principal. 2=semiannually. the following information about the bond is required or could be used as a substitute for required information: × Coupon payment frequency: expressed as the number of coupon payments in a year. The information in this document is the property of Morningstar. 4 . if the first coupon for a semiannual bond is June 30. 12=monthly. or day-count convention is not available. × First coupon date: date of the first coupon payment for the bond. Morningstar uses the evaluated price. If the clean price recommences at a future date. the return series for this bond restarts from that day forward. Morningstar does not calculate a return stream for a bond under the following conditions: × Coupon payment frequency. and so on. in whole or part. For the purpose of calculating daily return of bonds. × EOM: end-of-month. Inc..

in the case that both the first coupon date and the maturity date are unavailable for a bond that is not a zero-coupon bond. or for any other reason that may make the timing of the receipt of coupon payments differ from the entitlement date of the coupon. without the prior written consent of Morningstar. Inc. As stated in the Introduction. and it is on Dec. bond. or EOM. it is important to know whether coupon payment dates always fall on the last day of the month for the bond in question. All rights reserved. if the first coupon for a semiannual bond is June 30. 30 for a bond that is not EOM. accrued interest. and subsequent coupon payments are made on the same day of the month in regular intervals based on the coupon payment frequency. Inc. When the first coupon date is not available. 31 for an end-of-month. Inc. This section describes the calculation of the coupon payment and its related measure. the subsequent coupon payments are on May 31. The first coupon date indicates when the first coupon payment occurs. Morningstar does not make adjustments when coupon dates fall on weekends or national holidays. coupon payment frequency. Coupon Dates The following information is needed to determine the dates on which coupons are paid: first coupon date. For example. Because each month may have a different number of days. is prohibited. Morningstar uses the maturity date and works backward using the coupon payment frequency to generate a series of coupon payment dates. Similarly. 29 for a leap year. 28. 30. the next coupon is paid on Dec. in whole or part. 5 . if the first coupon for a quarterly EOM bond is Feb. and whether the coupon payment dates fall on the last day of the month. The section is not applicable to a zero-coupon bond as there is no period coupon payment. Morningstar Bond Return Calculation Methodology | June 30. Morningstar does not calculate a return stream. Nov. 2013 © 2013 Morningstar. The information in this document is the property of Morningstar. August 31. is a significant source of a bond's return. Reproduction or transcription by any means.Coupon Payment and Accrued Interest Coupon. and Feb. when the first coupon date falls on the month-end of a smaller month.. the interest payment of a bond.

it is not always true that adding all coupon payments for the year results in the annual coupon rate. one would intuitively expect the coupon payments to be the annual coupon rate divided by the number of periodic coupons in the year. without the prior written consent of Morningstar. While the clean price is obtained directly from third-party providers as the evaluated or theoretical price of the bond. The following formula is applicable to both coupon payment and accrued interest calculation since accrued interest is essentially prorated coupon payment: [1] Interestt = Coupon Rate • Day-Count Factort. is the clean price plus accrued interest. Accrued interest is also an important part of a bond's return. each with a unique way of handling the fact that the number of days between coupon payments varies. expressed as percentage of par value Coupon Rate = Annual coupon rate of a bond. Inc. Reproduction or transcription by any means. but this is not always the case.Coupon Payment and Accrued Interest (continued) Coupon Payment Amount and Accrued Interest At each coupon payment date. accrued interest and coupon payment must be calculated. This is because there are different day-count conventions. expressed as a percentage of par value Day-Count Factor t = Day-count factor on valuation day t Note: × Accrued interest is zero on a coupon date. Similarly. Inc. this is accrued interest. Since bond issuers do not distribute coupon payments on a daily basis. Inc. the market value of a bond. in whole or part. is prohibited. All rights reserved. Morningstar Bond Return Calculation Methodology | June 30.. where Interestt = Coupon payment or accrued interest on valuation day t. 6 . also known as the dirty price. The information in this document is the property of Morningstar. and so does the number of days in a year depending on whether it is a leap year. 2013 © 2013 Morningstar. a bond buyer must pay the seller for the amount of interest earned by the latter since the previous coupon date. On a daily basis.

For accrued interest calculation. is prohibited. 7 . In the case of coupon payment calculation. 3. one coupon period may have 181 days and the next coupon period 184 days. for a bond that pays a 4% coupon rate semiannually. Morningstar Bond Return Calculation Methodology | June 30. in whole or part. For example. it is the effective number of days between the previous coupon date and the valuation date. without the prior written consent of Morningstar. but the bondholder is paid the same amount on each coupon date. 2013 © 2013 Morningstar. all coupon payments are always for the same amount regardless of the length in the coupon period. The day-count convention determines the effective number of days between two dates in question.Coupon Payment and Accrued Interest (continued) The day-count factor is an essential step in the calculation of coupon payment and accrued interest for a bond. taking into account that there are 366 days in a leap year. Inc. regardless of how many actual calendar days set them apart. The coupon payment for the first coupon period is equally prorated among its 181 days for daily accrual. The information in this document is the property of Morningstar. 4. Actual/actual Actual/365 Actual/360 30/360 Actual/Actual Day-Count Convention The actual/actual day-count convention counts the actual number of days in the interest valuation period as well as the actual number of days of the year in question. and each coupon payment is prorated equally among the days in the coupon period for the purpose of daily accrual calculation.. and the coupon payment for the second coupon period is equally prorated among its 184 days. It is based on the bond's day-count convention and coupon payment frequency. which is 2% in this example. Under this method. and variations exist within the same general convention. The following sections address in detail Morningstar's methodology for the most commonly used day-count conventions: 1. Inc. All rights reserved. it is the effective number of days between the date of the coupon payment that is being calculated and the date of the previous coupon payment. Reproduction or transcription by any means. Inc. 2. There is no central authority defining day-count conventions.

Morningstar Bond Return Calculation Methodology | June 30. where Freq = Coupon payment frequency. Under this method. 2013 © 2013 Morningstar. 8 .Coupon Payment and Accrued Interest (continued) For the actual/actual day-count convention. and both the valuation date and the next coupon date are Aug. All rights reserved. while both the valuation date and the next coupon date are the coupon date in question. when calculating the day-count factor for the semiannual coupon payment on Aug. 2010. 2010. which is why the coupon payments are always the same throughout the bond's life. the sum of coupon amounts exceeds the annual coupon rate in a leap year for having gained an extra day of interest. The information in this document is the property of Morningstar. this reduces the formula to 1 over coupon frequency.. without the prior written consent of Morningstar. 15. Furthermore. the day-count factor on a given coupon or valuation date is [2] Day-Count Factort = ( 1 / Freq ) • ( NumPrev. 4=quarterly. 15. Reproduction or transcription by any means. Actual/365 Day-Count Convention The actual/365 day-count convention counts the actual number of days in the interest valuation period but assumes there are always 365 days in a year.Next = Number of days between the previous coupon date and the next coupon date Notes: × The coupon payment frequency is expressed as the number of coupon payments in a year: 1=annually. For example. 12=monthly. Inc. the previous coupon date refers to the date of the preceding coupon. 2=semiannually.t = Number of days between the previous coupon date and the valuation date NumPrev. and so on. in whole or part. Inc.Next ). coupon payments vary from coupon period to coupon period due to the differing length of each period. Intrinsically. the previous coupon date is May 15.t / NumPrev. Inc. × When calculating the day-count factor for a coupon payment on a given coupon date. 2010. expressed as number of coupon payments per year NumPrev. is prohibited. regardless of leap year.

the day-count factor on a given coupon or valuation date is [4] Day-Count Factort = NumPrev. The information in this document is the property of Morningstar. 15. in whole or part. Note: × Similar to the actual/365 day-count convention. the day-count factor on a given coupon or valuation date is [3] Day-Count Factort = NumPrev. coupon payments vary from coupon period to coupon period due to the differing length of each period. Actual/360 Day-Count Convention The Actual/360 day-count convention counts the actual number of days in the interest valuation period but assumes there are always 360 days in a year.t / 360. All rights reserved. Reproduction or transcription by any means. when calculating the day-count factor for the semiannual coupon payment on Aug.Coupon Payment and Accrued Interest (continued) For the actual/365 day-count convention. the sum of coupon amounts always exceeds the annual coupon rate for having gained five or six additional days of interest. when calculating the day-count factor for a coupon payment on a given coupon date. 15. the previous coupon date refers to the date of the preceding coupon. 2010. when calculating the day-count factor for a coupon payment on a given coupon date. while the valuation date is the coupon date in question. is prohibited. 2013 © 2013 Morningstar. For example. For the actual/360 day-count convention. and the valuation date is Aug. 9 . Under this method. 2010. 2010.. Furthermore. regardless of leap year. Note: × Similar to the actual/actual day-count convention. while the valuation date is the coupon date in question. Inc. the previous coupon date is May 15. Inc. Morningstar Bond Return Calculation Methodology | June 30. without the prior written consent of Morningstar. the previous coupon date refers to the date of the preceding coupon.t / 365. Inc.

depending on whether the bond is EOM that pays a coupon in February. such as 8 for Aug. expressed as a number Month Dt = Day number of the valuation day t (exceptions below). three days' worth of accrual is assigned to Feb. expressed as a number. in a regular year.. is prohibited. expressed as a number Mt = Month number that the valuation day t falls in. while the valuation date is the coupon date in question. when calculating the day-count factor for a coupon payment on a given coupon date. Reproduction or transcription by any means. 15. in whole or part. the previous coupon date refers to the date of the preceding coupon. Inc. 15. 2013 © 2013 Morningstar. 2010 DPrev = Day number of the previous coupon date (exceptions below). In a leap year. Inc. Those seven days are either the 31st or the first calendar day of a month that follows a 31-day month. 15. The spirit of this method is for all coupon payments to be the same amount regardless of the length in the coupon period. Morningstar Bond Return Calculation Methodology | June 30. Since the method assumes there are 30 days in a month and the daily accrual rate is constant. the daily accrual is zero for seven days each year. expressed as a number Note: × Similar to the actual/360 day-count convention. expressed as a number. expressed in number. 10 . Inc. without the prior written consent of Morningstar. where Yt = Year number that the valuation day t falls in. depending on whether the bond is EOM. For the 30/360 day-count convention. the day-count factor on a given coupon or valuation date is [5] Day-Count Factort = [(360 • ( Yt – YPrev ) + 30 • ( Mt – MPrev ) + ( Dt – DPrev)]/360. 28 or March 1. such as 15 for Aug. this is reduced to two days' worth of accrual. such as 2010 for Aug. Similarly. MPrev = 2010 number that the previous coupon date falls in.Coupon Payment and Accrued Interest (continued) 30/360 Day-Count Convention The 30/360 day-count convention assumes there are 30 days in a month and 360 days in a year. while holding the daily accrual rate constant. The information in this document is the property of Morningstar. regardless of leap year. 2010 YPrev = Year number that the previous coupon date falls in. All rights reserved.

Morningstar Bond Return Calculation Methodology | June 30. is prohibited. All rights reserved. Inc. Reproduction or transcription by any means. Inc.. 2013 © 2013 Morningstar. 11 . Inc. The information in this document is the property of Morningstar. without the prior written consent of Morningstar. in whole or part.

. Dt. without the prior written consent of Morningstar. 12 . Reproduction or transcription by any means. 2013 © 2013 Morningstar. All rights reserved. and the bond is EOM. the bond is EOM.Coupon Payment and Accrued Interest (continued) Exceptions: × The day number of the previous coupon day. DPrev. is changed to 30 when both of the following conditions occur: the previous coupon falls on the last day of February. and DPrev = 30 after applying the exceptions outlined in the previous two bullet points. is changed to 30 when both of the following conditions occur: the valuation day is the 31st of the month. Inc. in whole or part. is prohibited. is changed to 30 when all of the following conditions occur: the valuation day falls on the last day of February. Inc. The information in this document is the property of Morningstar. and the end of February is one of the periodic coupon dates for this bond. Morningstar Bond Return Calculation Methodology | June 30. Dt. × The day number of the valuation day. DPrev. × The day number of the valuation day. is changed to 30 when the previous coupon occurs on the 31st of the month. × The day number of the previous coupon day. Inc.

the clean price from the most recent past is carried over for up to five days. is prohibited.. The market value of a bond.t = ( Pt + AIt + Coupont ) / ( Pt-1 + AIt-1 ) . is the clean price plus accrued interest.Bond Total Return Daily Total Return The daily total return of a bond takes into consideration both capital appreciation and income. the dirty price could be different on each of these five days as coupon payments and accrued interest continue being calculated on a daily basis. 31. It is the combination of the change in market value of the bond and coupon payment received on the valuation date. × Accrued interest is zero on a coupon date. Reproduction or transcription by any means. The clean price is obtained directly from third-party providers as the evaluated or theoretical price of the bond. All rights reserved.1.t = Total return on day t. also known as the dirty price. 2013 © 2013 Morningstar. Inc. 26 is carried over to fill the missing clean price on these five days. if a bond is missing prices from Oct. 13 . If the clean price is also missing on Nov. and historical return prior to the Morningstar Bond Return Calculation Methodology | June 30. where TRt-1. The formula for the daily total return of a bond is as follows: [6] TRt-1. the return series for this bond restarts from that day onward. which is earned from the end of the previous day to the end of the valuation day Pt = Clean price on the valuation day t AIt = Accrued interest on the valuation day t Pt-1 = Clean price on the day prior to the valuation day AIt-1 = Accrued interest on the day prior to the valuation day Coupont = Coupon payment on the valuation day t Notes: × Coupon and accrued interest for a zero-coupon bond are zero. Inc. Only the clean price is carried over. in whole or part. 1. × Missing clean price: when the clean price of a bond is missing. 31. and the accrued interest and coupon payment are calculated based on formula [1] above. For example. Inc. The information in this document is the property of Morningstar. this exceeds the five-day carryover limit and the return stream is stopped as of Oct. without the prior written consent of Morningstar. the clean price from Oct. assuming that the latter occurs at the end of the day. If the clean price recommences at a future day. 27 to Oct.

t). Reproduction or transcription by any means. The information in this document is the property of Morningstar. Inc. When compounding. Daily Total Return Index To efficiently calculate the return between any two days. is prohibited. the portfolio is growing at the total return. without the prior written consent of Morningstar. Morningstar Bond Return Calculation Methodology | June 30.. Inc. coupon payments are assumed to be reinvested on the coupon payment date at the day's price (the dirty price is the same as the clean price as there is no accrued interest). Therefore. it is often helpful to think in terms of index level. 14 . Morningstar calls this data stream the daily total return index. where DRIt = Daily total return index on the valuation day t DRIt-1 = Daily return index on the day prior to the valuation day This concept assumes that total return compounds over time. in whole or part. An alternative view on the concept of compounding is to assume that the coupon is not reinvested but instead returned directly to the investor so that this cash flow exits the portfolio and does not produce a cash drag. compounding makes sense no matter whether one believes that coupon payments ought to be reinvested or withdrawn.Bond Total Return (continued) recommencement is erased because the interruption is too large to be considered continuous. The formula for it is as follows: [7] DRIt = DRIt-1 • (1+TRt-1. 2013 © 2013 Morningstar. In the absence of a cash drag. All rights reserved. Inc. in other words. growth in wealth such as growth of $100.