Yield Explained for Dummies

What is yield?

In terms of investments, yield refers to the income received on an investment over a particular period of time, such as a year, and is normally expressed as an annual percentage. Put in other words, yield is an indication of how much income an investor will receive annually in relation to the market value or initial cost of his or her investment. Investopedia describes yield as ‘a return measure for an investment over a set period of time, expressed as a percentage.’ Bonds and company shares are the two types of investments that are most commonly associated with yields. Share yields are referred to as dividends and yields in terms of bonds are called interest.  

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Calculations of yields of different types of investments

The basic formula to calculate an investment’s yield is as follows: Yield = (Income/Principal amount) x 100 Where: The numerator, income, can be replaced by:

• Net realised return (price increase plus dividends paid)
• Income
• Dividend per share
• Coupon (when bonds are involved)
• Net rental income

  The denominator, principal amount, can be replaced by:

• Current share price or current stock price
• Share purchase price or stock purchase price
• Market value
• Bond price or par value
• Real estate value
• The principal amount, which is the original investment amount

Keep in mind when calculating yield, there is an inverse relationship between price and yield. When price increases, yield decreases, and vice versa.  

Yield on shares (stock)

Shareholders of companies receive income in the form of dividends, normally distributed annually. Although, some companies pay dividends bi-annually or even quarterly. Regarding share-based investments, several types of yield can be used. For instance:

• Dividend yield

The formula to calculate the dividend yield of an investment in shares is used when the impact of share price fluctuations and dividend reinvestment is not taken into consideration. Example Harry wants to increase his investment portfolio by adding a share-based investment. After some research, he has to choose between companies AA and BB.   Company AA The current share price is R250.65 and the company distributes bi-annually a dividend of R8.70 per share. Company AA’s dividend yield looks as follows: Annual dividend per share = R17.40 (R8.70 x 2) Dividend yield = (Dividend per share/Current share price) x 100                            = (R17.40/R250.65) x 100 = 0.0694 x 100 = 6.94%   Company BB Company BB pays an annual dividend of R23.50 per share and its shares currently trade at R290,60 per share. The dividend yield of company B is calculated as follows: Dividend yield = (Dividend per share/Current share price) x 100                             = (R23.50/R290.60) x 100 = 0.0809 x 100 = 8.09% Based on the dividend yields of the two companies, Harry decides to invest in Company B. Although company B has a higher share price than company A, its dividend yield beats the yield of company A.  

• Cost yield

When the yield on an investment in a company is based on the purchase price of the shares, the yield is referred to as cost yield, or yield on cost, and is calculated as: Cost yield = (Net realised return/Share purchase price) x 100   Where:  

• Net realised return = Price increase + dividend paid.

For example: Sarah purchased shares of company Well Done at R120 per share and recently received a dividend of R15.20 per share. The current share price of Well Done is R135 per share. Well Done’s yield on cost is determined as follows: Price increase = R15 (R135 - R120) Cost yield = ((Price increase + Dividend paid)/Share purchase price) x 100                    = ((R15 + R15.20)/R120) x 100                    = (R30.20/R120) x 100 = 0.2517 x 100 = 25.17%  

• Current yield

However, Sarah prefers to calculate the yield on her investment based on the current market price of the company Well Done’s shares. To accomplish this, she uses the current yield formula. Hence, the yield on Sarah’s investment will now be calculated as follows: Current yield = ((Price increase + Dividend paid)/Current share price) x 100                          = ((R15 + R15.20)/R135) x 100                          = (R30.20/R135) x 100 = 0.2237 x 100 = 22.37% Noteworthy, the current yield (22.37%) of Sarah’s investment is lower than the cost yield (25.17%). The reason is that when a company’s share price increases, the current yield drops because of the inverse relationship between the share price and yield. Although, if the value of Sara’s shares increases, she will enjoy a greater return on her investment if the dividend payment stays the same. For instance, if the share price of company Well Done jumps to R150 per share, the current yield on her investment will be as follows:   Price increase = R30 (R150 - R120) Current yield = ((R30 + R15.20)/R150) x 100                          = (R45.20/R135) x 100 = 0.3348 x 100 = 33.48% However, the yield on cost will still be higher than the current yield according to the following calculation:   Cost yield = ((R30 + R15.20)/R120) x 100                    = (R45.20/R120) x 100 = 0.3767 x 100 = 37.67%  

Yield on bonds

A bond is a type of debt instrument issued by bond issuers, such as governments of countries, companies, corporations, and local governments, in order to raise money for projects, developments, and operations. Simply put, when investors buy bonds from bond issuers, they provide loans to the issuers. Concerning yield on bonds, the following terms are important:

• Basis points (BPS) are used to measure changes in a bond’s yield. One basis point reflects a 0.01% change (a 1% change = 100 basis points). For example, when a bond’s yield increases from 8% to 8.25%, it moves 25 basis points, which equals 0.25% (25 BPS x 0.01%).

 

• A bondholder (bond owner) is an entity or individual who receives the coupon payment.

 

• Coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value.

It is usually a fixed rate that is based on the face value of the bond. For example, a bond with a face value of R2 000 and a coupon of 10% means that a bondholder will receive annually interest of R200. However, at present, variable interest rates are also quite common. Bondholders should expect to receive coupon payments twice a year. Do not confuse yield with a bond’s coupon.  

• Coupon dates are the dates on which the bond issuer will pay interest. Usually, interest is paid twice a year.

 

• Face value, also called par value, is the amount a bond will be worth when it reaches maturity, payable to the bondholder. It is also the amount used by the bond issuer to calculate coupon (interest) payments.

 

• Maturity date, simply called maturity is the date on which the bond will mature, and when the bondholder will receive an amount, represented by the face value of the bond, from the bond issuer.

Yield on bonds, also known as interest yield, can be calculated in different ways, depending on factors such as the duration of the bond, the coupon, and whether it is a fixed or variable interest rate. Bond yields can be expressed, inter alia, as a percentage of the issued bond price, a percentage of the current price of the bond, or as a percentage of the face value of the bond, referred to as nominal yield, or an estimation of the bond’s yield if it is held to its maturity date.   Examples of bond yields:

• Nominal yield

A government bond with a face value of R2 000 and a coupon of 7% matures in one year. The nominal yield will be calculated as follows: Nominal yield = (Annual interest earned/Face value of bond) x 100 Where annual interest = 7% x R2 000 = R140 Nominal yield = (140/R2 000) x 100 = 0.07 x 100 = 7% Nominal yield is usually calculated on a per-year basis, subjected to annually changes  

• Current yield

For instance, James plans to purchase corporate bonds at a current price of R200 per bond from corporation EE. The bonds have a coupon of 6.75% or R6.25 per bond a year. Current yield = (Coupon/Current bond price) x 100 = (R6.25/R200) x 100 = 0.03125 x100 = 3.13%  

• Yield to maturity (YTM)

Yield to maturity (YTM) refers to the total rate of return a bondholder can expect to receive if a bond is held to its maturity date. In other words, YTM is the total rate of return that a bond owner will earn when the bond issuer makes all interest payments and repays the original principal amount. Essentially, YTM represents a bond’s internal rate of return (IRR) if kept to its maturity date. Yield to maturity is regarded as a long-term bond yield, expressed as an annual rate. Calculating YTM can be quite complicated. Although the following description of the basic YTM formula will give an indication of what the calculation of YTM entails.   Description of the basic formula to calculate YTM: Numerator

1. Deduct the bond’s market value from its face value
2. Divide the answer obtained in step 1 by years to maturity.
3. Add the bond’s cash flow to the answer obtained in step 2

Denominator

1. Find the sum of the bond’s face value and market value
2. Divide the sum of step 1 by 2

Divide the numerator’s total by the denominator’s total and multiply the answer by 100 to express YTM as a percentage. Yield to maturity is also called redemption yield or book yield.  

• Yield to call (YTC)

Yield to call (YTC) is applicable to callable bonds, also referred to as redeemable bonds. A callable bond is a type of bond that can be redeemed or paid off by the bond issuer before the bond’s maturity date. Typically, a bond is redeemed when interest rates fall to a level lower than when the bond was originally issued. A bond issuer will call back (buy back) the original bond from the bondholder at its face value and then reissue a bond at a lower coupon rate. YTC refers to the bond’s yield at the time of its call date. The formula to calculate the YTC is as follows: Yield to call = (i +((P_c  - P_m)/ n)/ ((P_c + P_m)/2) x 100   Where:

• i = Annual interest (coupon)
• P_c = Call price
• P_m = Current market price
• n = Number of years until call

  Example of YTC Leanne is the owner of a bond with an annual coupon of R10 and a call price of R70 000 in 5 years. The bond’s current market price is R10 500.   The YTC of Leanne’s bond will be calculated as follows: YTC = (R10 + ((R70 000 - R10 500)/5) / ((R70 000 + R10 500)/2) x 100 = (R10 + (R59 500/5)) / (R80 500/2) x 100 = (R10 + R11 900)/(R40250) x 100 = (R11 910) / (R40 250) x 100 = 0.2959 x 100 = 29.59%  

Rental income yield

Rental income yield is used by owners of real estate who want to determine how much they will receive in rental income from a property, after allowing for operating expenses. Rental income yield is also referred to as capitalisation rate or cap rate in real estate. The formula to determine the rental income yield in real estate is: Rental income yield = (Net annual rental income / Real estate value) x 100   Example: Leonard is keen to buy a flat and rent it out to generate more income. He can by a flat for R 1 100 000 and will be able to rent it out for R9 000 a month. Monthly costs amount to R4 500.   Leonard’s rental income yield will look as follows: Net monthly rental income = R4 500 (R9 000 - R4 500) Net annual rental income = R54 000 (R4 500 x 12) Rental income yield = (R54 000/R1 100 000) x 100 = 0.0490 x 100 = 4.9%

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