Yield (Finance) - Explained
What is Yield?
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Table of ContentsWhat is Yield?How Does Yield Work?Yield on Stock InvestmentsYield on Bond InvestmentsYield to Maturity (YTM)Yield to worst (YTW)Yield to Call (YTC)Tax Equivalent YieldRegulation of Yield CalculationsYield as an Investment IndicatorConclusion
What is Yield?
A yield refers to the returns that an investment generates over a period of time. It is the earnings of the investment or interest that an investor receives for holding a security. The amount of investment, current market value, face value or par value determine the yield of an investment. The amount of cash, interest and dividends received on a security is the yield, it is however different from the total return on an investment. Yield is expressed as an annual percentage, also an investor can either have a known yield or anticipated yield depending on the nature of the security and the duration.
How Does Yield Work?
Yield is often calculated on an annual basis, it is the earnings or returns on investment that is received on a holding security. It is the return or income obtained on an investment over a particular period of time. Gains on an investment can either result from rise in price or dividend paid on it. Total return on an investment is however a more detailed term as it measures the totality of return on investment. While total return is calculated as; Total Return = (Price Increase + Dividend Paid) / Purchase Price, Yield is calculated as; Yield = Net Realized Return / Principal Amount Yield is a part of the total return, the principal return in yield also varies because it depends on the type of yield being calculated.
Yield on Stock Investments
Two types of yield can be used for stock investments, they are yield on cost (cost yield) and current yield. Cost yield is calculated based on the purchase price of the investment, the formula for calculating cost yield is; Cost Yield = (Price Increase + Dividend Paid) / Purchase Price Current yield on the other hand refers to the yield of an investment that is based on the current market price rather than the purchase price. The formula for calculating current yield is; Current Yield = (Price Increase + Dividend Paid) / Current Price Therefore, the yield on stock investment is realized by cost yield and current yield.
Yield on Bond Investments
When calculating yield on bonds investments, different measures can be applied and this is determined by the nature of the bond investment. A nominal yield is the annual interest paid on the bond investment. Nominal yield is calculated as; Nominal Yield = (Annual Interest Earned / Face Value of Bond) The nominal yield of a treasury bond that pays an annual interest rate of 5% with a face value of $1,000 and a maturity period of one year will be calculated as; Nominal Yield = (Annual Interest Earned / Face Value of Bond) = $50/$1000 = 0.05 = 5% For a floating interest rate bond, its yield will be realized by variable interest that can change over the lifespan of the bond. The interest rate, tenure or duration of the bond and terms of this type of bond also determine how its yield will look like. Also, index-linked bond have their yields aligned with a particular index. Hence, the interest payment will change or be adjusted to suit the fluctuations that the index experiences.
Yield to Maturity (YTM)
Yield to maturity (YTM) refers to the total returns or the earnings of a bond if it is held to the maturity date. Bonds often have maturity dates, this can vary depending on the type or nature of the bond. The YTM of a bond is different from the nominal yield that is calculated annually, YTM is the yield that is often constant through the holding period of a bond till its maturity. It is the average yield, book yield or redemption yield that a bond attracts if it is held until the maturity date.
Yield to worst (YTW)
Callable or exchangeable bonds often have yield to worst, this is the lowest yield or worst possible yield/return that can be expected on bonds of such nature. YTW is the worst yield that can be received if the issuer of the bond uses prepayments, call back or similar provisions. YTW are calculated on call dates which can be at any time. YTW is a risk measure in transactions of bonds that ensure that some yields are received even in the worst situations.
Yield to Call (YTC)
Yield to call (YTC) is calculated based on the market price, coupon rate and the length of time to the cal date of a bond. YTC is the yield, returns or earnings if a bond as at the time of its call date. Callable bonds which can be redeemed by the issuer before its maturity date attract YTC. However, yield to call can only be received if a bond is called or redeemed by the issuer before it fully matures.
Tax Equivalent Yield
Municipal bonds are often issued by states and regional governments to finance capital expenditures and public projects. Municipal bonds have tax-equivalent yield (TEY) and are non-taxable, they are used to finance social or public projects such as seaports, health facilities, airports, schools, roads, among others. TEY is the yield that municipal bonds attract.
Regulation of Yield Calculations
In the United States, the Securities and Exchange Commission (SEC) introduced a standard measure for yield calculation, this is to minimize the variations in calculating yields because different companies calculate yields based on their practize or conventions. The standard calculating measure developed by the SEC is called SEC yield. This standard measure has however reduced the excess liberty that issuers, fund managers and companies enjoy while calculating yield value. The returns or earnings that a mutual fund accumulate over a given period of time is regarded as the Mutual fund yield. When the annual income distribution payment of the fund is divided by the value of a funds shares, the mutual fund yield id accounted for. The valuation of mutual funds is not static, it changes as it is affected by the calculated net asset value. When calculating mutual fund yields, the income (dividends and interest) that the investors receive are included.
Yield as an Investment Indicator
In investment with lower risks often result in higher returns or earnings for investors. A higher yield might be as a result of low risk of the investment but it can also be as a result of a fall in market value of the security involved. When there is a fall in the market value of a security, there will be a decrease in the value of the denominator used in the calculation of yield which in turn cause a higher yield. Also, an excessively high yield might be because a stock price is crashing of the issuer is paying too much dividends. A high yield without increase in stock price means the company is paying high dividends despite decline in earnings which will cause greater problems in the future.
Yield is a crucial factor that investors and fund managers look out for when making investment decisions. The earnings (yield) that investors expect from a particular investment motivates them to choose the investment or look for an alternative. Although, yield is an important factor, checking the past records or previous patterns of the investment is also essential. This will help to determine the trends of yield on the investment over a period of time. Current market price and price movements are also vital in the calculation of yield.