Know These Yields
As an investor, you will often come across the term “yield.” It refers to the income return on your investment. The percentage quoted is generally annualized. There are many different types of yields and it can sometimes get confusing. Today we’ll go over some major ones.
Yield to Maturity
If you invest in bonds, an important yield to know is the yield to maturity (YTM). This is the measure of the annualized return you earn if you held the bond to maturity and collected all coupon payments. Note that the YTM is different from the bond’s coupon rate.
The formula is quite complex and it’s not recommended to try to solve for the YTM by hand. However, the availability of a financial calculator or an Excel spreadsheet will make things greatly easier.
For example, let’s say you buy a 6% bond (face value $1,000) that will mature in exactly 3 years for $980. It pays the interest semiannually. This means you will receive six coupon payments of $30 every six months. And at the end of six years you also receive the principal $1,000. Its YTM, or the annualized return you earn during the holding period, is 6.75%.
The discount on the bond increased your return. If your purchase price was, say, $1,050, your YTM would be only 4.2%.
The bottom line is that the YTM provides a more accurate rate of return than the coupon rate. Plus, by comparing one bond’s YTM to another bonds’ YTM, it allows you to make apple-to-apple comparisons when making a purchasing decision.
Annual Percentage Yield
Another yield you will often come across is the annual percentage yield (APY). One common example would be a bank offering a certain nominal interest rate and also stating the APY. The two rates differ in that the APY takes compounding into account.
Let’s say a bank offers a savings account with an interest rate of 2.4%, and interest is compounded monthly.
What this means is that every month, you earn 1/12 of 2.4% (0.2%) on the value of your savings account. So if you started with $1,000, you will have $1,002 at the end of Month 1.
Then in Month 2, you will earn interest on the original $1,000 plus the extra $2. Your total interest for Month 2 will be $2.004, making your total account value $104.004. Thus for the next month you will earn interest against that $104.004, and so forth.
At the end of twelve months, you will have earned $24.27 in interest, making your APR 2.427%. The difference of $0.27 due to compounding is tiny because we started with just $1,000. If we started with a much bigger starting amount, the dollar difference would be bigger.
If you invest in stocks, then the dividend yield is the yield you most often come across. Unlike the previous two yields mentioned, it is easy to calculate the dividend yield: you divide the annual dividend by the stock price. A $50 dollar stock that pays $2 in dividend a year has a 4% yield.
However, there are more than one kind of dividend yields. The two most common are the indicated yield and the trailing-twelve-month (TTM) yield. Consider a company that paid $0.24, $0.24, $0.24, and $0.25 over the past four quarters with a stock price of $20.
The indicated dividend yield takes the latest received dividend and annualizes it. So in this example, the indicated yield would be: $0.25 x 4 ÷ $20 = 5%.
On the other hand, the TTM dividend yield adds up the dividends paid in the last twelve months and divides by the stock price. In the example it would be: ($0.24 x 3 + $0.25) ÷ $20 = 4.85%.
Possible Big Difference
In our example, the difference isn’t big since there is only a small difference being the past dividends and the projected future dividend. However, the difference could be big—e.g., if the company paid a special dividend in the past year that it likely won’t repeat.
In this case, the TTM yield presents an inflated view of the company’s actual dividend level. Thus, it’s important to find out which yield is being displayed when making an investment decision.
The final thing I want to reiterate is that the quoted yield is usually annualized. For example, let’s say you see a six-month CD with a quoted interest rate of 3% (for ease of explanation assume no compounding).
If you invest $1,000, you won’t get $30 in interest over the six months. Your actual interest will be $15. You only invest for half a year, so you only get half of the annual 3% interest.
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