Knowing the differences between yield and return can help you evaluate an investment’s income potential.
Yield refers to how much income an investment generates, separate from the principle. It’s commonly used to refer to interest payments an investor receives on a bond or dividend payments on a stock.
Yield is often expressed as a percentage rate, based on either the investment’s market value or purchase price. For example, imagine bond A has a $1,000 face value and pays a semiannual coupon of $10. Over one year, bond A yields $20, or 2 percent. This is known as the cost yield because it’s based on the cost or value of the bond.
However, most people buy bonds on the secondary market and not directly from the issuer, meaning they pay more or less than face value. If you are considering purchasing the same bond A for $900, the $20 coupon payments based on the current $900 price would be a yield of 2.2 percent for you. This is known as the current yield because it’s based on the current price of the bond.
Yield is also a commonly used term when discussing dividend stocks. For instance, say you purchase 100 shares of XYZ for $50 ($5,000 total). Each quarter, XYZ pays a dividend of 50 cents per share. Over a year, you would receive $200 in dividend income (50 cents x 4 quarters = $2 x 100 shares). Your initial investment of $5,000 yielded 4 percent ($200 / $5,000 x 100).
Of course, it’s likely that XYZ’s share price changed over that same time, which is where return can be helpful. Return is a measure of an investment’s total interest, dividends and capital gains, expressed as a financial gain or loss over a specific timeframe.
When assessing an investment, return provides a glimpse of the investment’s prior performance and helps determine if a particular investment has been profitable over time. If stock XYZ ended the year at $55 per share, your total return would be equal to the increase in share price plus the dividends, or $700 ($5 + $2 = $7 x 100 shares). That same $5,000 investment returned 14 percent ($700 / $5,000 x 100).
Yield and return should be used together to help you evaluate an investment’s overall performance.
Consider the earlier example of stock XYZ. Let’s say XYZ shares lost value over the year and are now valued at $45 each. The total return for that investment would be negative; you would have lost $300, or 6 percent ($200 in dividends – $500 in principal). However, the yield didn’t change. You still received $200 in dividend income.
Investing in stocks based on their yield could prevent you from having to sell shares to generate income. In a market downturn, this can help you avoid selling shares at a loss.
Return can be used to assess not only individual investments, but also an entire portfolio to determine the overall performance and pinpoint whether certain underperforming investments should be sold, and the money reinvested elsewhere.
Risk is an important consideration for an investment’s yield because high-yield investments may carry more risk.
For instance, if company B wants to sell bonds, but investors think company B is at risk of missing coupon payments and/or going bankrupt, the company likely needs to pay a higher yield on those bonds to compensate for the risk. To assess the risk of a bond in comparison to its yield, investors often look at the bond’s rating. It’s no surprise that the lowest-rated debt often has the highest yield. In fact, the term “high-yield” and “junk” are often used interchangeably when discussing poorly rated debt.
With stocks, if a company is paying high dividends, it may not be reinvesting in the company and growth, which could jeopardize the investment long term. It’s important to look at how the dividend payments fit into the company’s overall financials. If, for instance, the company consistently reports negative earnings (i.e., losing money) but is still paying dividends, it may be tapping into cash on hand or other sources to afford those payments. This could signal long-term problems or even future elimination of dividends.
Investors should consider their investment goals and tolerance for risk when determining if an investment is the right fit for their portfolio. And once you’re ready to pull income from your investments, consider making an appointment with a financial professional to assess your goals and help make sure your withdrawal plans are aligned with your investment objectives.
Diversification is a key part of managing investment risk. Read about 7 diversification strategies for your investment portfolio.