Yield (finance)

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In finance, the yield on a security is a measure of the ex-ante return to a holder of the security. It is a component of return on an investment, the other component being the change in the market price of the security. It is a measure applied to fixed income securities, common stocks, preferred stocks, convertible stocks and bonds, annuities and real estate investments.

Contents

There are various types of yield, and the method of calculation depends on the particular type of yield and the type of security. Because of these differences, yield comparisons between different types of financial products should be treated with caution.

Fixed income securities

The coupon rate (or nominal rate) on a fixed income security is the interest that the issuer agrees to pay to the security holder each year, expressed as a percentage of the security's principal amount (par value). [1] [2] [3]

The current yield is the ratio of the annual interest (coupon) payment and the bond's market price. [4] [5]

The yield to maturity is an estimate of the total rate of return anticipated to be earned by an investor who buys a bond at a given market price, holds it to maturity, and receives all interest payments and the payment of par value on schedule. [6] Unlike current yield, it takes into account the payment of principal to the bondholder when the bond matures.

For bonds with embedded call or put options:

Par yield assumes that the security's market price is equal to par value (also known as face value or nominal value). [8] It is the metric used in the U.S. Treasury's daily official "Treasury Par Yield Curve Rates". [9]

Preferred shares

The dividend rate is the total amount of dividends paid in a year, divided by the principal value of the preferred share. The current yield is those same payments divided by the preferred share's market price. [10] If the preferred share has a maturity or call provision (which is not always the case), yield to maturity and yield to call can be calculated.

Common shares

The current dividend yield is the annualized cash dividend (in dollars, RMB, Yen, etc.) divided by the current market price of one share. [11] Most web sites and reports are updated with the expected future year's payments, not the past year's.

REITs, royalty trusts, income trusts, annuities

Distribution yields from REITs, royalty trusts, income trusts and annuities often include return of capital, cash that exceeds the income earned.[ citation needed ]

Real estate and property

Several different yields are used as measures of a real estate investment, including initial, equivalent and reversionary yields.

Initial yield is the annualised rents of a property expressed as a percentage of the property value. [12] E.g. £100,000 passing rent per annum £1,850,000 valuation 100000/1850000 = 0.054 or 5.4%

Reversionary yield is the anticipated yield to which the initial yield will rise (or fall) once the rent reaches the ERV. [13] E.g. £150,000 ERV per annum £1,850,000 valuation 150000/1850000 = 0.081 or 8.1%

Equivalent yield lies somewhere in between the initial yield and reversionary yield, it encapsulates the DCF of the property with rents rising (or falling) from the current annualised rent to the underlying estimated rental value (ERV) less costs that are incurred along the way. The discount rate used to calculate the net present value (NPV) of the DCF to equal zero is the equivalent yield, or the IRR. [14]

The calculation not only takes into account all costs, but other assumptions including rent reviews and void periods. A trial and error method can be used to identify the equivalent yield of a DCF, or if using Excel, the goal seek function can be used.[ citation needed ]

Factors affecting the yield

All financial instruments compete with each other in the financial markets. Investor perceptions of risk influence the yield they require to justify investment in a particular security. Higher yields allow owners to recoup their investments sooner, and so lessen risk. All other things being equal, the weaker the credit rating of the issuer, the higher the yield must be. This reflects the tendency for investors to require compensation for the additional risk that the issuer may default on its obligations to pay interest and repay the principal at par value. [15]

Yield levels vary with expectations of inflation and the general outlook for the economy (the business cycle). Fears of high inflation in the future mean that investors ask for a higher yield today to protect their purchasing power.

The yield on a fixed income security is inversely related to financial market interest rates. If market rates rise, for example due to inflation or a change in the economy, the price of a bond or note falls, driving its yield higher to maintain parity with market rates. [16] Conversely, if market rates decline, then the price of the bond should increase, driving its yield lower, all else being equal.

Under normal market conditions, long-term fixed income securities (for example, a 10-year bond) have higher yields than short-term securities (e.g., a 2-year bond). This reflects the fact that long-term securities are more exposed to the uncertainties of what could happen in the future — especially changes in market rates of interest. Therefore, longer maturity securities have more potential price volatility. [17] The relationship between yield and maturity is described by the yield curve.

Special cases

Coupon payments from floating rate bonds and notes and Treasury Inflation Protected Securities are reset periodically based on a specified benchmark. It is not possible to accurately calculate the future stream of coupon payments from these securities, so yield to maturity and internal rates of return cannot be calculated. In this case, other metrics must be used. [18] [19] [20]

See also

Related Research Articles

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In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged – depending on the terms – to provide cash flow to the creditor. The timing and the amount of cash flow provided varies, depending on the economic value that is emphasized upon, thus giving rise to different types of bonds. The interest is usually payable at fixed intervals: semiannual, annual, and less often at other periods. Thus, a bond is a form of loan or IOU. Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure.

<span class="mw-page-title-main">Municipal bond</span> Bond issued by a local government

A municipal bond, commonly known as a muni, is a bond issued by state or local governments, or entities they create such as authorities and special districts. In the United States, interest income received by holders of municipal bonds is often, but not always, exempt from federal and state income taxation. Typically, only investors in the highest tax brackets benefit from buying tax-exempt municipal bonds instead of taxable bonds. Taxable equivalent yield calculations are required to make fair comparisons between the two categories.

<span class="mw-page-title-main">Convertible bond</span> Type of bond

In finance, a convertible bond or convertible note or convertible debt is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.

<span class="mw-page-title-main">United States Treasury security</span> US government debt instruments

United States Treasury securities, also called Treasuries or Treasurys, are government debt instruments issued by the United States Department of the Treasury to finance government spending in addition to taxation. Since 2012, U.S. government debt has been managed by the Bureau of the Fiscal Service, succeeding the Bureau of the Public Debt.

<span class="mw-page-title-main">Yield to maturity</span> Rate of return of an investment

The yield to maturity (YTM), book yield or redemption yield of a bond or other fixed-interest security, such as gilts, is an estimate of the total rate of return anticipated to be earned by an investor who buys a bond at a given market price, holds it to maturity, and receives all interest payments and the capital redemption on schedule. It is the (theoretical) internal rate of return : the discount rate at which the present value of all future cash flows from the bond is equal to the current price of the bond. The YTM is often given in terms of Annual Percentage Rate (A.P.R.), but more often market convention is followed. In a number of major markets the convention is to quote annualized yields with semi-annual compounding ; thus, for example, an annual effective yield of 10.25% would be quoted as 10.00%, because 1.05 × 1.05 = 1.1025 and 2 × 5 = 10.

<span class="mw-page-title-main">Fixed income</span> Type of investment

Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the principal amount on maturity. Fixed-income securities — more commonly known as bonds — can be contrasted with equity securities – often referred to as stocks and shares – that create no obligation to pay dividends or any other form of income. Bonds carry a level of legal protections for investors that equity securities do not — in the event of a bankruptcy, bond holders would be repaid after liquidation of assets, whereas shareholders with stock often receive nothing.

<span class="mw-page-title-main">Bond valuation</span> Fair price of a bond

Bond valuation is the determination of the fair price of a bond. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.

In finance, bond convexity is a measure of the non-linear relationship of bond prices to changes in interest rates, the second derivative of the price of the bond with respect to interest rates. In general, the higher the duration, the more sensitive the bond price is to the change in interest rates. Bond convexity is one of the most basic and widely used forms of convexity in finance. Convexity was based on the work of Hon-Fei Lai and popularized by Stanley Diller.

The current yield, interest yield, income yield, flat yield, market yield, mark to market yield or running yield is a financial term used in reference to bonds and other fixed-interest securities such as gilts. It is the ratio of the annual interest (coupon) payment and the bond's price:

<span class="mw-page-title-main">Floating rate note</span>

Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.

A convertible security is a financial instrument whose holder has the right to convert it into another security of the same issuer. Most convertible securities are convertible bonds or preferred stocks that pay regular interest and can be converted into shares of the issuer's common stock. Convertible securities typically include other embedded options, such as call or put options. Consequently, determining the value of convertible securities can be a complex exercise. The complex valuation issue may attract specialized professional investors, including arbitrageurs and hedge funds who try to exploit disparities in the relationship between the price of the convertible security and the underlying common stock.

In finance, interest rate immunization is a portfolio management strategy designed to take advantage of the offsetting effects of interest rate risk and reinvestment risk.

The coupon rate of a fixed income security is the interest rate that the issuer agrees to pay to the security holder each year, expressed as a percentage of the security's principal amount or par value. The coupon rate is typically stated in the name of the bond, such as "US Treasury Bond 6.25%". Unlike current yield, it does not vary with the market price of the security.

Fixed income analysis is the process of determining the value of a debt security based on an assessment of its risk profile, which can include interest rate risk, risk of the issuer failing to repay the debt, market supply and demand for the security, call provisions and macroeconomic considerations affecting its value in the future. It also addresses the likely price behavior in hedging portfolios. Based on such an analysis, a fixed income analyst tries to reach a conclusion as to whether to buy, sell, hold, hedge or avoid the particular security.

A bond fund or debt fund is a fund that invests in bonds, or other debt securities. Bond funds can be contrasted with stock funds and money funds. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation. Bond funds typically pay higher dividends than CDs and money market accounts. Most bond funds pay out dividends more frequently than individual bonds.

Reinvestment risk is a form of financial risk. It is primarily associated with fixed income securities, in the form of early redemption risk and coupon reinvestment risk.

Pull to Par is the effect in which the price of a bond converges to par value as time passes. At maturity the price of a debt instrument in good standing should equal its par.

The Z-spread, ZSPRD, zero-volatility spread or yield curve spread of a bond is the parallel shift or spread over the zero-coupon Treasury yield curve required for discounting a pre-determined cash flow schedule to arrive at its present market price. The Z-spread is also widely used in the credit default swap (CDS) market as a measure of credit spread that is relatively insensitive to the particulars of specific corporate or government bonds.

The following outline is provided as an overview of and topical guide to finance:

In finance, par yield is the yield on a fixed income security assuming that its market price is equal to par value. Par yield is used to derive the U.S. Treasury’s daily official “Treasury Par Yield Curve Rates”, which are used by investors to price debt securities traded in public markets, and by lenders to set interest rates on many other types of debt, including bank loans and mortgages.

References

  1. ↑ Fabozzi, Frank J. (1996). Bond Markets, Analysis and Strategies. Upper Saddle River, New Jersey.: Prentice-Hall, Inc. p. 3. ISBN   0-13-339151-5.
  2. ↑ Thau, Annette (2001). The Bond Book (Revised ed.). New York: McGraw-Hill. p. 3. ISBN   0-07-135862-5.
  3. ↑ Melicher and Welshans (1988). Finance: Introduction to Markets, Institutions and Management (7 ed.). Cincinnati, Ohiio: South-Western Publishing Company. p. 481. ISBN   0-538-06160-X.
  4. ↑ Martinelli, Lionel, Priaulet, Phillippe and Priaulet, Stephane (2003). Fixed Income Securities: Valuation, Risk Management and Portfolio Strategies. Chichester, England: John Wiley & Sons. p. 49. ISBN   0-470-85277-1.{{cite book}}: CS1 maint: multiple names: authors list (link)
  5. ↑ Thau, Annette (2001). The Bond Book (Revised ed.). New York: McGraw-Hill. pp. 102–104. ISBN   0-07-135862-5.
  6. ↑ Thau op cit p. 56.
  7. ↑ Fabozzi op cit p. 40-41.
  8. ↑ Martinelli, Lionel; Priaulet, Philippe; Priaulet, Stephane (2003). Fixed-Income Securities: Valuation, Risk Management, and Portfolio Strategies. Chichester, England: John Wiley & Sons Ltd. p. 54. ISBN   0-470-85277-1.{{cite book}}: CS1 maint: multiple names: authors list (link)
  9. ↑ Girola, James. "The Yield Curve for Nominal Treasury Issues" (PDF). U.S. Department of the Treasury. Retrieved 14 January 2022.
  10. ↑ Melicher and Welshans op cit p. 244.
  11. ↑ Nikbakht, Ehsan and Groppelli, A.A. Finance (sixth ed.). Haupaggue, New York: Barron's Educational Series, Inc. p. 267. ISBN   978-0-7641-4759-3.{{cite book}}: CS1 maint: multiple names: authors list (link)
  12. ↑ Initialyield.com (May 2012). "Glossary, Initial Yield". Initial Yield. Retrieved 2012-05-01.
  13. ↑ Initialyield.com (May 2012). "Glossary, Reversionary Yield". Reversionary Yield. Retrieved 2012-05-01.
  14. ↑ Initialyield.com (May 2012). "Glossary, Equivalent Yield". Equivalent Yield. Retrieved 2012-05-01.
  15. ↑ Thau op cit p. 40.
  16. ↑ Melicher and Welshans op cit p. 481.
  17. ↑ Thau op cit p. 31.
  18. ↑ Thau op cit p. 102-104, 205.
  19. ↑ Fabozzi, Frank J. (1997). The Handbook of Fixed Income Securities. New York: McGraw-Hill. pp. 67, 260–262. ISBN   0-7863-1095-2.
  20. ↑ "TIPS". The Wall Street Journal - Markets. Retrieved 24 April 2022.
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