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In finance, the yield on a security is a measure of the ex-ante return to a holder of the security. It is measure applied to common, preferred stock, convertible stocks and bonds, fixed income instruments, including bonds, including government bonds and corporate bonds, notes and annuities.
There are various types of yield, and the method of calculation depends on the particular type of yield and the type of security.
Yield to maturity is applied to a fixed income security. It is the holder's ex-ante total return, calculated assuming it is held until maturity, and assuming there is no default, using the internal rate of return (IRR) method.
Because of these differences, the yields comparisons between different yields measured on different types of financial products should be treated with caution. This page is mainly a series of links to other pages with increased details.
Bonds, notes, bills
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.
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 which resemble interest. However, preferred "interest" is actually in the form of a dividend. This is a significant accounting difference as preferred dividends, unlike debt interest, are charged after taxes and below net income, therefore reducing net income and ultimately earnings per share. Preferred shares may also contain conversion privileges which allow for their exchange into common stock.
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.
Preferred trust units
Like preferred shares but units in a trust. Trusts have certain tax advantages to standard corporations and are typically deemed to be "flow-through" vehicles. Private mutual funds trusts are gaining in popularity in Canada following the changes to tax legislation which forced many publicly traded royalty trusts to convert back into corporations. Investors seeking the high yields typically associated with the energy royalty trusts are increasingly investing in private mutual energy fund trusts.
Common shares will often pay out a portion of the earnings as dividends. The dividend yield is the total dollars (RMB, 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.
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
Real estate and property
Several different yields are used as measures of a real estate investment, including initial, equivalent and reversionary yields.
Initial yield is the annualised rents of a property expressed as a percentage of the property value. E.g. £100,000 passing rent per annum £1,850,000 valuation 100000/1850000 = 0.054 or 5.4%
Reversionary yield is the anticipated yield to which the initial yield will rise (or fall) once the rent reaches the ERV. E.g. £150,000 ERV per annum £1,850,000 valuation 150000/1850000 = 0.081 or 8.1%
Equivalent yield lies somewhere in between the initial yield and reversionary yield, it encapsulates the DCF of the property with rents rising (or falling) from the current annualised rent to the underlying estimated rental value (ERV) less costs that are incurred along the way. The discount rate used to calculate the net present value (NPV) of the DCF to equal zero is the equivalent yield, or the IRR.
The calculation not only takes into account all costs, but other assumptions including rent reviews and void periods. A trial and error method can be used to identify the equivalent yield of a DCF, or if using Excel, the goal seek function can be used.
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 their 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 (a low price vs the coupon) 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.