What is a yield? Dividend & bond yields - Share Centre

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What is a yield?

The differences between dividends and bonds

What they are and why they matter

Investors often focus primarily on capital growth as a means of profiting from their investments.

However, the income an asset generates is at least, if not more, important to overall returns, particularly if that income is reinvested.

A share may generate an income stream in the form of a dividend. A bond usually promises to pay a regular coupon over its lifetime. And a property will generate rental income.

One way to compare the income streams on offer is by looking at the ‘yield’ on an asset. This shows the annual income an investor can expect to receive as a percentage of the price of the asset. Yields move inversely to prices – assuming the income generated by an asset stays the same, when the price of the asset rises, the yield will fall, and vice versa.

As a rule of thumb, the higher the yield on offer, the riskier the investment. If the investment has to offer the prospect of an unusually high yield to entice investors, it suggests that the market is sceptical of its ability to deliver.

Here are two of the most common forms of yield investors are likely to encounter: dividend yields, and bond yields.

Dividend yield: how to calculate it

Many companies pay out dividends to their shareholders. This is one of the main attractions for income-oriented 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%. If the share price rises to £2, the dividend yield will fall to 2.5%.

You can calculate the dividend yield based on historic data (the amount paid out in dividends over the past year, say), or on expectations of future payouts – these can be based on analyst forecasts, or the company’s own predictions.

Dividend yields: what influences them?

Several factors affect dividend yields. At a ‘big picture’ level, the income available from lower-risk assets such as cash or bonds will have an effect on the yields that shares have to offer to attract investors.

Certain types of share generally offer higher yields than others. Fast-growing companies might not pay any dividend at all, preferring to reinvest all profits in growing the company. Investors will buy these stocks primarily hoping for capital growth.

Meanwhile, shares in sectors seen as offering stable, more predictable growth – such as utilities – might offer higher yields than the market as a whole, to compensate for relatively low expected capital growth. So when looking at the dividend yield on offer from a share, it makes sense to compare it to similar companies in its sector.

If a dividend seems unusually high, it may be an indication that the share is undervalued. However, it may also be a warning sign. The market may be concerned that the dividend will have to be cut or scrapped altogether.

So investors need to do their homework (by checking how well a dividend is covered by profits and cash flow, for example) and invest in a diverse portfolio of shares to spread their risk.

Bond yields: the basics

When you buy a bond, you are lending money to someone – usually a company or government. Unlike a dividend, the coupon on a bond must be paid – it cannot be cut or cancelled, or the issuer is considered to have defaulted.

There are several types of bond yield. There’s the ‘coupon rate’ or interest rate, which is simply the rate that the bond pays if it was bought at its initial face value. So a 5% Treasury Gilt 2018 for example, has a coupon rate of 5%.

More useful is the ‘running yield’ or ‘income yield’. This takes account of what you actually pay for the bond. So if the aforementioned bond trades at £110, the income yield is 4.5% (£5/£110 as a percentage). However, this assumes you’ll be able to sell for the same price you bought at, which is not necessarily the case. 

So most useful of all is the yield to maturity, or redemption yield. This takes account of not only the annual coupon payments, but also the timing of those payments, plus the amount you will receive when the bond is redeemed.

For example, in the above instance, you’ve bought the bond for £110, but you’ll only get £100 when it matures. So in this case, the yield to maturity is 2.2% (assuming the bond matures exactly four years from the purchase date). It’s a fiddly calculation, but it’s easily available from various financial websites.

Bond yields: what influences them?

Bond coupon payments are usually fixed. This means that bond yields are influenced mainly by two factors: the attractiveness of that fixed income payment compared to other sources of income available; and the security of that payment – how likely is the issuer to maintain the payments and return the principal?

These factors boil down to two things: interest rates, and individual credit quality. If interest rates are rising (perhaps due to rising inflation), then the yield on a bond will have to rise to remain attractive (and therefore the bond price will fall). Similarly, if interest rates fall, the bond yield will fall, and bond prices will rise. Generally, the longer a bond has to go until maturity, the bigger the impact of changing interest rate expectations.

Credit quality also influences individual bond yields. A bond issuer such as the UK or US government is seen as very safe – these governments are extremely unlikely to default on their debt. A bond issued by a heavily-indebted company would be far riskier. So investors will demand a higher yield to invest in this sort of company than they would to buy an equivalent gilt. Again, a good rule of thumb to remember is: the higher the yield, the greater the risk.