What is the difference between yield and total return? THe textbook cites this as the limitation for yield pickup trade, but how are these two different? Do they differ in holding period(i.e. yield is the return if u hold it to maturity) or yield reflects only part of total return(just like price return )? Thanks.
total returns is a realized annualized return and always measured after the fact.
YTM is the future annualized return promised under the assumption that reinvestment rate = YTM itself , which is almost never the case.
So the realized ( i.e total ) return is almost never equal to the original YTM assumption except for a zero coupon bond held to maturity .
The difference between yield and total return in the context of yield pickup trade is as follows.
yiled includes only the yield or the interest part of the purchase decision.
Total return includes the yield and the post purchase bond price change as well.
Manager considering “Yield pickup trade” typically buys a lower rated bond for additional yield, which the lower rated bond provides. May be she thinks that the lower rated bond provides additional yield, yet is not as risky as the market thinks and he buys the lower rated bond.
Total return on the other hand includes yield and the price change over the time horizon as well.
For example, if I bougt a lower rated bond for its higher yield and after my purchase the bond’s credit quality declined further and the price of the bond declines after my purchase. This means I am getting a higher yield, yet if I sold the bond, I would incur a loss and hence my total return may not be good.
So, just looking at yield in isolation (as yield pickup trade does) is not a good idea.
Hope this clarifies.
Great, thanks!