What it means
Yield turns a cash amount into a rate so that investments of different sizes can be compared. A $60 annual coupon means nothing on its own, but $60 on a $960 investment is 6.25% a year, and that figure can be set beside a savings account or a rental property.
The important nuance is that yield moves in the opposite direction to price. If the income stays fixed and the price of the asset falls, the yield rises, which is why a suddenly high dividend yield is often a warning about the share price rather than good news about the dividend.
Several different yields are in common use and people rarely say which one they mean. Current yield uses only this year's income over today's price, yield to maturity also folds in the gain or loss from holding a bond until it repays its face value, and gross yield on property is rent over purchase price before any costs.
For a business, yield matters on both sides of the balance sheet. Treasury teams compare the yield on surplus cash against the interest rate on borrowings, and if a company is borrowing at 8% while earning 3% on deposits, holding a large cash balance costs it 5% a year in lost value.
Yield also says nothing about risk or about getting the original money back. A 12% yield usually means the market has priced in a real chance that the income stops or the capital is impaired, so yield should always be read next to the credit quality of whoever is paying it.
In practice
Real-world examples.
Example
A manufacturer parks $2,000,000 of surplus cash in a money market fund yielding 4.2% a year, producing $84,000 of interest income. The finance director compares that with the 7.5% cost of the company's revolving credit facility and repays $1,500,000 of the drawn balance instead, saving $112,500 a year in interest.
Example
A property investor pays $320,000 for a flat that rents for $1,600 a month, or $19,200 a year. The gross yield is $19,200 / $320,000 = 6%, but after $4,800 of service charges, insurance and letting fees the net yield is $14,400 / $320,000 = 4.5%.
Example
An income fund manager notices a listed retailer yielding 11% against a sector average near 4%. Rather than buying, she checks dividend cover and finds the payment is 130% of earnings, a sign it is being funded from reserves and is likely to be cut.
Formula
Calculation
Current yield = Annual income / Current market price
Take a corporate bond with a face value of $1,000 paying a 6% annual coupon. The annual income is $1,000 x 6% = $60.
Interest rates have risen since the bond was issued and it now trades at $960.
Current yield = $60 / $960 = 0.0625, or 6.25%.
The same logic applies to shares. A share trading at $60 that pays an annual dividend of $2.40 has a dividend yield of $2.40 / $60 = 0.04, or 4%. If the share price falls to $48 and the dividend is held steady, the yield rises to $2.40 / $48 = 0.05, or 5%, even though nothing about the dividend itself has improved.Case study
Seen in the real world.
Harlequin Reserve Partners is an invented, illustrative investment club used here to show how yield can mislead. The club held $400,000 across five income shares and reported an average yield of 7.4%, which the members treated as a dependable annual income of $29,600.
Two of the holdings carried yields above 10%, and those yields had risen only because the share prices had halved. When both companies cut their dividends the following year, the club's actual income fell to $19,200, a drop of $10,400, even though it had not sold a single share.
The lesson in this fictional case was that the headline yield described past payments divided by a falling price, not a forecast. Harlequin rewrote its rules to cap any single holding at a yield of 8% at the point of purchase and to check dividend cover before buying.
Watch out
Common mistakes.
- Treating yield as a guaranteed return, when it is only the income rate at a moment in time and can fall to zero if the payment is cut.
- Comparing a gross yield on property with a net yield on a bond, which flatters the property because its running costs have not been deducted.
- Assuming a high yield signals a bargain, when it usually reflects a price that has fallen for a reason the market has already spotted.
Questions
People also ask.
Is yield the same as total return?
No, total return adds the change in the asset's price to the income, so an asset can have a healthy yield and still deliver a negative total return.
Why do bond yields rise when bond prices fall?
Because the coupon is fixed in cash terms, so the same income divided by a lower price gives a higher percentage.
Which yield should I use for a bond I intend to hold to maturity?
Yield to maturity, because it includes the pull towards face value at redemption as well as the coupon payments.
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