Yield is the income return that an investment generates. It is one of the two ways of making money from investing, along with capital growth.
Shares may generate an income stream in the form of dividends (your share of company profits), whereas bonds usually promise to pay a regular coupon over their lifetime. Property can generate rental income.
Many companies pay out dividends to their shareholders, which attracts investors. The dividend yield on a share is simply the annual dividend per share, expressed as a percentage of the share price. So if a company pays out 5p a year per share in dividends and the share price is £1, then the dividend yield is 5%.
Fast-growing companies might not pay any dividend at all, preferring to reinvest all profits in order to grow the company. Investors will buy these stocks primarily hoping for capital growth.
Meanwhile, companies in sectors seen as offering stable, more predictable growth often offer higher yields to compensate for relatively low expected capital growth. It therefore makes sense to compare companies in the same sector.
In general, the higher the yield on offer, the riskier the investment is. The market is sceptical if a company has to offer the prospect of unusually high dividends to entice investors. You need to do your homework, for example, by checking how well a dividend is covered by profits and cash flow.
There are three types of bond yield:
1. Coupon rate (or interest rate)
The rate that the bond pays if it was bought at its initial face value, for example, a Tesco 5% 2024 bond would have a coupon rate of 5%.
2. Income yield (or running yield)
This takes account of what you actually pay for the bond. If the Tesco bond above is trading at £110, the income yield would be 4.5% (£5/£110x100). This assumes you’ll be able to sell for the same price you bought at, which is not necessarily the case.
3. Redemption yield (or yield to maturity)
This takes account of the annual coupon payments, the timing of those payments and the amount you will receive when the bond is redeemed.
If you’ve bought the Tesco bond above for £110, but you’ll only get £100 when it matures, the redemption yield would be 2.2% (assuming the bond matures exactly four years from the purchase date).
Bond coupon payments are usually fixed. This means that bond yields are influenced mainly by two factors:
How attractive is a bond’s fixed income payment compared to other sources of income? If interest rates are rising (perhaps due to inflation), a bond’s yield will have to rise to remain attractive (and therefore the bond price will fall) and vice versa. Generally, the longer until maturity, the bigger the impact of changing interest rate expectations.
How likely is the bond issuer to maintain the payments and return the initial capital? A bond issuer such as the UK or US government is seen as very safe, however a heavily-indebted company would be far riskier - investors demand a higher yield to invest in this sort of company.