The problem is that "yield" has many different meanings, and thus many different implications for investors.
The basic dilemma is that yield may or may not be synonymous with total return—the bottom line for investors.
The term "yield," on its own, is an imprecise term that can mean any number of things—ranging, for instance, from:
The more precise definition of yield becomes apparent when a qualifier is used—for instance, dividend yield, current yield, or yield to maturity.
Investors who seek an income component from their investments often look at various yields to indicate which investments will provide a higher amount of their return in the form of annual income payments. Thus, for example, income-seeking investors may prefer a stock with a higher dividend yield than one with a lower dividend yield.
Yields also can be used to indicate the relative risk of different securities. Typically, securities with higher risk must offer higher yields to compensate for the greater risk. Thus, for example, dividend-paying stocks whose firms are having financial troubles will tend to have higher dividend yields than the stocks of financially secure firms, and the bonds of companies with lower credit ratings will have higher current yields than those with higher credit ratings.
Yield is also sometimes used to indicate a security's total return. However, it is important for investors to understand the difference between "total return" and most uses of the term "yield." The bottom line for any investor, for any investment, is total return.
Total return incorporates capital gains and losses, as well as any annual income thrown off by the investment in the form of dividends or interest payments.
Total return is also specific to the individual investor's particular experience—the purchase price paid for the investment, the holding period, the sales price, and the actual income payments received. Most uses of the term "yield" refer only to the income component and do not include a gain or loss component.
Investors—particularly those individuals who are interested in bonds—sometimes make the mistake of equating quoted yields with total return. However, most quoted bond yields ignore gains or losses in the market value of the bonds, an important component of total return even in a bond holding. Although there is one bond yield measure, as we shall see, that comes close to the total return concept (yield to maturity), it is only an estimate of total return based on assumptions that may or may not apply to the individual investor who has purchased the bond.
A dividend yield is calculated by dividing the indicated annual dividend (the expected dividend for the next four quarters) by the closing price of the stock. It simply provides the historical annual dividend relative to the current market price in percentage form.
How is it useful? When compared to other dividend yields measured over the same time period, it tells you the annual income you can expect from this stock relative to other stocks: If you invested today at the current price, you will receive more annual income as a percentage of your original investment from a stock with a higher dividend yield than one with a lower dividend yield. The higher dividend yield also indicates there is a greater risk that dividends may be reduced or not paid in the future. Dividend yield reflects only income, and does not take into consideration gains or losses.
A bond's current yield is calculated by dividing the annual interest payment by the current market price of the bond. Like a dividend yield, it only captures one aspect of total return—the income generated by the investment. It ignores any changes in value from gains or losses.
How is it useful? The current yield will tell you how much interest income you will receive each year from the bond relative to the price you are paying for the bond, assuming you were purchasing it today at the bond's current price.
A bond's coupon yield is the simple interest paid by a bond annually as a percentage of maturity value. The coupon yield, also known as the coupon rate, is the annual interest rate established when the bond is issued.
How is it useful? The coupon yield tells how much income you will receive each year you own the bond, expressed as a percentage of the maturity value of the bond. For example, a bond that is issued with a $1,000 value at maturity and a 4.5% coupon yield will pay $45 in annual interest payments.
This amount is figured as a percentage of the bond's maturity value and will not change during the lifespan of the bond, regardless of how the price of the bond fluctuates in the secondary markets. This is unlike the bond's current yield, which fluctuates based on the bond's current market price.
Yield to Maturity
A bond's yield to maturity is one yield figure that comes close to a total rate of return concept. However, it makes a number of assumptions. It assumes that the bond is held to maturity, and that all interest payments are reinvested at a rate that is equivalent to the yield to maturity.
Yield to maturity comes close to the total return concept because it takes into account all possible sources of income from a bond, including coupon income, earnings on reinvested income, and capital gains or losses due to the difference between the price paid when the bond was purchased and the return of principal at maturity.
However, it is not a return you will actually receive on a bond, but a rate of return you could expect to receive if you held the bond to maturity and were able to reinvest all income at the yield-to-maturity rate. Your actual return will be determined by a number of factors, including whether you actually do reinvest income, the actual rate of return you receive on any reinvested income, and the difference between the price you paid originally and your selling price (if you sell before it matures) or the value at maturity.
How is it useful? Yield-to-maturity quotes are useful because they allow you to compare different kinds of bonds—those with dissimilar coupon yields, bonds selling at a discount or premium, and different maturities. For example, how do you compare a 20-year zero-coupon bond that provides no annual income payments but is purchased at a deep discount to its value at maturity, with a 15-year bond that has a 6% coupon yield and is selling at a premium to its maturity value? Looking at the current yield to maturity of the two bonds allows you to make an apples-to-apples comparison of their relative "expected" rates of return. But remember, you would only receive the "expected" rates of return if all of the assumptions held true—you held the bond to maturity, and were able to reinvest all income at the same rate as the yield to maturity.
The taxable-equivalent yield is the yield on a taxable bond (or taxable bond mutual fund) that would result in the same after-federal-tax yield to an investor as a given tax-exempt bond (or tax-exempt bond mutual fund). It is calculated by dividing the tax-exempt yield by 1.00 minus your marginal federal income tax rate (in decimal form).
How is it useful? The bottom line for taxable investors is not just total return, but total return after taxes. This yield is useful for high tax bracket investors who may receive a higher aftertax rate of return by investing in tax-exempt municipal bonds rather than taxable bonds. It is used to compare the yield of a tax-free bond to that of a taxable bond in order to see which bond has a higher aftertax yield.
30-Day SEC Yield
A yield quoted by bond mutual funds, the 30-day SEC yield is calculated according to a formula determined by the Securities and Exchange Commission (SEC). It is primarily a snapshot of the interest distributions from the fund over the prior 30 days, with some adjustments.
How is it useful? The 30-day SEC yield is a standardized yield calculation for bond funds that allows investors to compare the yield performance of one bond fund to another. However, the figure is a reflection of the past 30 days and is not necessarily an indication of future yield.
In addition, the calculation implies the bonds will be held until maturity, and in practice bonds funds tend to trade actively and do not hold bonds to maturity. For this reason, a mutual fund's income yield (see below) may be a better measure of a bond fund's income-generating potential.
A mutual fund's yield is the per share annual income distribution (which could include interest, dividends and short-term gains net of expenses) made by a mutual fund, divided by its year-ending net asset value, plus any capital gains distributions made during the year.
How is it useful? This yield is similar to a dividend yield and would be higher for income-oriented stock funds and lower for growth-oriented stock funds. The figure only reflects income—it is not total return. The yield also may be distorted if the fund reports short-term capital gains as income.
The expected annual cash dividend relative to the current market price of the stock. Calculated by dividing the indicated annual cash dividend by the closing price of the stock.
The annual interest payment of a bond relative to the current market price of the bond. Calculated by dividing the annual interest payment by the current market price of the bond.
The annual interest payment of a bond relative to the bond's maturity value. Set at the time of issue, this will remain unchanged over time.
Yield to Maturity
An estimate of the total return on a bond if it is held to maturity and if all interest payments are reinvested at the yield-to-maturity rate.
Yields for Muni Bond Investors
The yield on a taxable bond (or taxable bond mutual fund) that would result in the same after-federal-tax yield as a given tax-exempt bond (or tax-exempt bond mutual fund). Calculated by dividing the tax-exempt yield by 1.00 minus your marginal federal income tax rate (in decimal form).
Mutual Fund Yields
30-Day SEC Yield
A standardized yield quoted by bond mutual funds calculated according to a formula determined by the SEC. Primarily a snapshot of the interest distributions from the fund over the prior 30 days, with some adjustments.
The income distributed by a mutual fund relative to its current per share value. Calculated by dividing the fund's per share annual income distribution (including interest, dividends and short-term gains net of expenses) by its year-ending net asset value plus any capital gains distributions made during the year.