How Interpreting Yields Can Boost Your Portfolio!

Have you ever listened to a business recap on your way home from work, heard the term “Investors are searching for higher yields”, and wondered what it meant? Return on investment comes in two forms: income and capital gains. Yields explain the income (cash flow) portion in percentage terms. They are useful for comparing investments of similar structure and risk. For a fixed income instrument like a bond, the coupon is the cash flow. For equities like a stock, it is the dividend.

Issuers promise investors cash flows at a future date in return for capital up front to fund their businesses. Investors like the low volatility of the investment as well as receiving payments in absolute amounts at a finite date. A dollar today is worth more than a future dollar of tomorrow. A company will do everything in its power not to miss a payment or reduce the dividend. These signal to investors that there is economic trouble ahead, which means a sharp drop in the stock price (and bye-bye bonuses!)

Investment Yields

The yield is the ratio of cash flows to current market prices. It is not the same as actual ROR . Whether you are getting a 4% coupon on a bond or a dividend of $1/share, your actual return is $4 or $1, regardless of the current price of the security. The yield is the current return of a security at a given point in time relative to its market price. Let’s look at an example.

You buy $100,000 (par) worth of Apple corporate bonds with a coupon of 2% for $105,000. This means the price per bond is $105 (105,000/100,000). Your current yield is 1.91% (2/105). What does this mean? Well, anytime the yield is lower than the actual coupon indicates the bonds are trading at a premium (more than par). If the price drops to $103.75, the yield is 1.93%. The yield is what a security is returning at a given point in time.

Let’s look at another example, this time with a stock. This should be a little clearer since most of us won’t invest directly in individual bonds, but we may in individual stocks. Suppose you invest in Coca Cola at $80 per share. Let’s also suppose they pay a dividend of $5/year. What is the current yield? If you said 6.25%, you would be correct (5/80). If a month from now the price rises to $85, the yield falls (inverse relationship to price) to 5.88%.

Conclusion

Calculating yields is nothing more than understanding basic math. There is a numerator (cash flow) and denominator (security price). If you want to increase your yields, you can do one of two things: increase the numerator by selecting investments with higher cash flows or decrease the denominator by selecting investments with lower prices.

Yields are great for comparing like investments (securities of similar structure and similar risks). In our above example, it isn’t prudent to compare the bond with the equity because equities have higher risks. They should have higher yields. If they don’t, then that is an indication that equity markets are overvalued.

Bond prices usually trade close to par ($100), so there isn’t as much fluctuation with prices as there are with equities. If you buy a bond at a premium, then your yield will always be below the coupon. Look for equities with dividend yields at least 4%.

You now have an excellent tool for selecting individual securities. Plus, you can understand what those finance nerds you see on TV and hear on the radio are talking about!

Let me know what other finance topics you’d like to see discussed!

See you next time