TOTAL RETURN ANALYSIS
Monte Carlo simulations and option-adjusted spreads are greatly superior to the earlier methods of projecting return. As with the other measures discussed previously in this chapter, a major drawback is that they also implicitly assume that the securities being analyzed are held to maturity. While some conservative investors operate in this fashion, many investors will invest in securities to be held over finite horizons. In order for them to analyze bonds in a fashion consistent with their investment management style, they must incorporate different analytical techniques. A commonly used technique, called total return analysis, allows the investor to evaluate returns over different horizons and interest rate scenarios. It has the additional advantage of allowing the investor to specify reinvestment returns, which is quite helpful in analyzing securities such as inverse floaters and inverse IOs.
The total return from an MBS is defined by the following parameters:
• The cost of the security at the time of purchase.
• The security’s projected cash flows, which include scheduled and unscheduled principal payments, interest, and reinvestment income (interest-on-interest and interest-on-principal).
• The security’s projected value at the horizon date.
The total percentage return (i.e., the returns over the time horizon) can be calculated as follows: