Yield (finance)
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In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return. Yield applies to various stated rates of return on stocks (common and preferred, and convertible), fixed income instruments (bonds, notes, bills, strips, zero coupon), and some other investment type insurance products (e.g. annuities).
The term is used in different situations to mean different things. It can be calculated as a ratio or as an internal rate of return (IRR). It may be used to state the owner's total return, or just a portion of income, or exceed the income.
Because of these differences, the yields from different uses should never be compared as if they were equal. This page is mainly a series of links to other pages with increased details.
Bonds, notes, bills
The nominal yield or coupon yield is the yearly total of coupons (or interest) paid divided by the Principal (Face) Value of the bond.
The current yield is those same payments divided by the bond's spot market price.
The yield to maturity is the IRR on the bond's cash flows: the purchase price, the coupons received and the principal at maturity.
The yield to call is the IRR on the bond's cash flows, assuming it is called at the first opportunity, instead of being held till maturity.[1]
The yield of a bond is inversely related to its price today: if the price of a bond falls, its yield goes up. Conversely, if interest rates decline (the market yield declines), then the price of the bond should rise (all else being equal).
There is also TIPS (Treasury Inflation Protected Securities), also known as Inflation Linked fixed income. TIPS are sold by the US Treasury and have a "real yield". The bond or note's face value is adjusted upwards with the CPI-U, and a real yield is applied to the adjusted principal to let the investor always outperform the inflation rate and protect purchasing power. However, many economists believe that the CPI under-represents actual inflation. In the event of deflation over the life of this type of fixed income, TIPS still mature at the price at which they were sold (initial face). Losing money on TIPS if bought at the initial auction and held to maturity is not possible even if deflation was long lasting.
Like bonds, preferred shares compensate owners with scheduled payments. The payments are usually called dividends, although they may technically be considered interest.
The dividend yield is the total yearly payments divided by the principal value of the preferred share.
The current yield is those same payments divided by the preferred share's market price.
If the preferred share has a maturity (not always) there can also be a yield to maturity and yield to call calculated, the same way as for bonds.
Common shares will often pay out a portion of the earnings as dividends. The dividend yield is the total dollars (Yen, etc) paid in a year divided by the spot price of the shares. Most web sites and reports are updated with the expected future year's payments, not the past year's.
The price/earnings ratio quoted for common shares is the reciprocal of what is called the earnings yield. EarningsPerShare / SharePrice.
Annuities
The life annuities purchased to fund retirement pay out a higher yield than can be obtained with other instruments, because part of the payment comes from a return of capital. $YearlyDistribution / $CostOfContract.
REITs, royalty trust, income trusts
Like annuities, distribution yields from REITs, Royalty trusts, and Income trusts often include cash that exceeds the income earned: that is return of capital. $YearlyDistribution / $SharePrice.
How to evaluate the yield (%)
All financial instruments compete with each other in the market place. Yield is one part of the total return of holding a security. A higher yield allows the owner to recoup his investment sooner, and so lessens risk. But on the other hand, a high yield may have resulted from a falling market value for the security as a result of higher risk.
Yield levels vary mainly with expectations of inflation. Fears of high inflation in the future mean that investors ask for high yield today.
The maturity of the instrument is one of the elements that determines risk. The relationship between yields and the maturity of instruments of similar credit worthiness, is described by the yield curve. Long dated instruments typically have a higher yield than short dated instruments.
The yield of a debt instrument is generally linked to the credit worthiness and default probability of the issuer. The more the default risk, the higher the yield would be in most of the cases since issuers need to offer investors some compensation for the risk.