Yield

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What is Yield?

Yield is the amount of income generated by an investment, expressed as a percentage of the investment value.

At the most basic, an investment’s yield is the amount of income it generates in a year divided by its total cost.

Basic Example

Investment Cost: $10,000

Annual Interest Earned: $500

Annual Yield: $500 / $10,000 = 5%

Why Important

Investors want to ensure they put their money to the best possible use. Yield calculations are used to compare different investment options to see which ones will be the most profitable.

Yield vs. Return

Yield and return are both expressions of investment income, but yield is used to predict how profitable an investment will be in the future, while return calculations are retrospective.

 

Yield Return
Forward-looking Backward-looking
Estimate of income that will be earned Accurate calculation of income that has already been earned
Based on assumptions Based on historical data

 

Types of Yield

There are many types of yield calculations that use different information to predict the return of different types of investments.

Some yield calculations take into account the power of compounding, assuming the investor reinvests all proceeds from the investment, which can make them very complex.

Nominal Yield
  • Annual Interest / Investment Value
  • Used for bonds
Cost Yield
  • Annual Income / Investment Purchase Price
  • Used for stocks
Dividend Yield
  • Annual Dividend Income / Current Share Price
  • Used for stocks
Current Yield
  • Annual Income / Current Investment Value
Effective Yield
  • The annual yield of an investment based on compounding
  • Will be greater than nominal, cost, or current yield because it assumes reinvestment of annual income
  • Relatively complex calculation
Yield to Maturity

(YTM)

  • The average annual yield of a bond, assuming it is held until maturity and pays a consistent rate of interest
  • Assumes compounding of reinvested annual interest payments
  • Used for bonds
  • Long-term predictive calculation
  • Very complex

Yield and Risk

Generally, riskier investments have higher yields. For example, a bond issued by a struggling company will carry a higher coupon rate than one issued by the U.S. government because investors need to be compensated for the increased risk of default.

Similarly, an investor looking for higher yields might invest in a new tech company rather than an established retailer. While the retailer’s stock is not likely to lose much value—making it a low-risk investment—most of the company’s big growth is behind it. The new tech company is likely to fail, which makes it risky, but if the company does well, a small high-risk investment now could be a huge moneymaker in a few short years.

Fun Facts

  • So-called “junk bonds” have such a high risk of default that they carry very high coupon rates and some of the highest yields available.

References

http://www.investopedia.com/terms/y/yield.asp

http://www.investopedia.com/ask/answers/04/090304.asp

http://www.investopedia.com/terms/y/yieldtomaturity.asp

Yield to Maturity, Nominal Yields, and Current Yields

http://www.investopedia.com/terms/e/effectiveyield.asp

http://www.investopedia.com/terms/n/nominalyield.asp

http://www.accountingtools.com/definition-yield

http://www.moneycontrol.com/glossary/mutual-fund/investment-yield_513.html

http://www.investinganswers.com/financial-dictionary/bonds/effective-yield-1013

http://www.investopedia.com/ask/answers/073115/what-relationship-between-current-yield-and-risk.asp

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