Yield

Financial Dictionary -> Investing -> Yield

The yield of a debt instrument (such as bonds, shares, annuities, etc.) is basically the return that a holder will receive for keeping the instrument for a set period of time. This definition, of course, is far from being exhaustive, all the more so as the term often encompasses different nuances of meaning, depending on its context. It is, therefore, the goal of this article to throw some light on the different ways in which the term is used by financial experts.

The word yield most often comes up in connection with bonds, where the concept acquires the following meanings:

- nominal yield (also know as coupon yield) or the interest rate of a bond which has been determined at its issuance;
- current yield which represents the interest rate of a bond as percentage of its current value;
- yield to maturity i.e. the cash that the bond holders will receive if they keep it until its maturity date and;
- yield to call or the return which is due to the holder if a bond is called before its maturity date.

Depending on the amount of their yield, bonds are divided into two large groups - junk bonds and investment grade bonds. Despite the connotations suggested by their name, the first type of bonds offers the greater yields; hence, they are also called high yield bonds. However, there is a catch -- the risk of losing money invested in them is also greater. The truth is that these bonds are offered by more unstable companies with lower credit ratings, forcing them to pay bigger interest rates in order to attract capital. Investment grade bonds, on the other hand, pay smaller yields but investing in them is much more secure, as the companies which issue them are generally well-established and unlikely to default.

When it comes to shares, one distinguishes between dividend yields and current yields. Thus, the dividend yield of a preferred share represents the dividends per share, which a shareholder receives per year, divided by the price of that share. For the estimation of the current yield of shares, the annual dividends are divided by the market price. The situation is similar in view of common shares: the dividend yield of a share is estimated as a percentage of its annual dividends and its spot price.

Besides the meaning of each of these terms, the prospective investor in bonds or shares should also know the factors that play a role in the estimation of the yield's amount. In general, the following two rules apply: first, the yield of a debt instrument is proportionate to the length of its maturity period and, second, it is inversely proportionate to the safety of the investment. In other words, the longer and riskier the investment, the greater the yield it generates.