The primary purpose of most bond funds is to provide investors with income. But those who focus exclusively on a bond fund's yield are only seeing part of the picture. Investors must also consider the fund's total return, which is the combination of yield and the return provided by principal fluctuation.
What is the Yield?
Yield is defined as the income return on investment. This refers to the interest or dividends received from a security and is usually expressed as an annual percentage based on the investment's cost, its current market value, or its face value.
By this definition, the yield would mainly be cash thrown off by the investment with no invasion of principal. In some cases, this may not be true. As an example, some closed-end funds (CEF) will use the return of the investor's principal to keep their distributions at the desired level. Investors in CEFs should be aware of whether their fund is engaging in this practice and also what the possible implications are.
Investors focusing strictly on yield are typically looking to preserve the principal and allow that principal to generate income. Growth is often a secondary investing consideration. This is especially true of fixed-income vehicles such as CDs, bonds, and depository accounts.
Dividend-paying stocks have become a popular vehicle for their yields on corporate earnings, which in many cases are higher than a typical fixed-income investment.
Yield is the income returned on an investment, such as the interest received from holding the security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value. Yield may be considered known or anticipated depending on the security in question, as certain securities may experience fluctuations in value.
Yield is forward-looking. Furthermore, it measures the income, such as interest and dividends, that an investment earns and ignores capital gains. This income is taken in the context of a specific period. It is then annualized with the assumption that the interest or dividends will continue to be received at the same rate.
A bond yield can have multiple yield options depending on the exact nature of the investment. The coupon is the bond interest rate fixed at issuance, and the coupon rate is the yield paid by fixed-income security. The coupon rate is the annual coupon payments paid by the issuer relative to the bond's face or par value.
The current yield is the bond interest rate as a percentage of the current price of the bond. The yield to maturity is an estimate of what an investor will receive if the bond is held to its maturity date.
What is Return?
Return is the financial gain or loss on an investment and is typically expressed as the change in dollar value of an investment over time. Return is also referred to as total return and expresses what an investor earned from an investment during a certain period. Total return includes interest, dividends, and capital gain, such as an increase in the share price. In other words, a return is a retrospective or backward-looking.
For example, if an investor bought a stock for $50 and sold it for $60, the return would be $10. If the company paid a dividend of $1 during the time the stock was held, the total return would be $11, including the capital gain and dividend. A positive return is a profit on an investment, and a negative return is a loss on an investment.
Total return includes interest, capital gains, dividends, and distributions realized over a given period of time. In other words, the total return on an investment or a portfolio includes both income and appreciation.
Total return investors typically focus on the growth in their portfolio over time. They will take distributions as needed from a combination of the income generated from the yield on various holdings and the price appreciation of certain securities. While total return investors do not want to see the overall value of their portfolio diminished, preservation of capital is not their main investment objective.
What Is the Difference Between the Rate of Return and Yield?
Rate of return and yield describes the performance of investments over a set period (typically one year), but they have subtle and sometimes important differences. The rate of return is a specific way of expressing the total return on an investment that shows the percentage increase over the initial investment cost. Yield shows how much income has been returned from an investment based on initial cost, but it does not include capital gains in its calculation.
Rate of return can be applied to nearly any investment while yield is somewhat more limited because not all investments produce interest or dividends. Mutual funds, stocks, and bonds are three common types of securities that have both rates of return and yields.
Yield vs Return
The yield of an investment is the income it earns. An investment usually expresses its yield as a percentage. For example, the interest or dividends security produces over a certain period of time can be its yield. The yield of investment uses the investment's face value, or what an investor originally paid for a stock. Also, yield factors in an investment's liquidity or its current market value.
An investment's return, however, is the dollar amount an investment earns or loses over time. An investment's return also accounts for dividends earned, interest earned, and capital gains.
Yield isn't as predictable as a return. However, sometimes investors can anticipate yield, depending on the security and its predictability.
Yield and return look similar, but they are different. Most people think the two terms to be one and the same.
When talking of return, it is what an investor has earned on his investment during a certain period of time during the past. Return generally takes into account interest, capital gain, an increase of share price and dividends. Return can be called as retrospective or what one has earned in the past.
In contrast to Return, Yield is prospective or advanced looking. Yield measures income like interest and dividends that are earned through an investment ignoring capital gain. In yield, the income is taken in the perspective of a certain period of time and then annualized, with the supposition that the dividends and interests will continue to be got at the same rate.
When yield can be called as a percentage increase on investments, a return can be called an absolute dollar amount. Yield usually refers to the annualized number, whereas return refers to any period of investment, maybe one year or two years.
Return can also be said to be the overall change in value with the assumption that the fund's dividends and capital gains are reinvested. On the other hand, yield depicts the income and earnings of funds on its investments. Unlike return, the yield is the measure of income and not capital gains.
When talking of bonds, a return is an interest payment on principle. Yield denotes the price of the bond.
Yield is the income that a fund pays on either a monthly or quarterly basis. The investor can either take this income in the form of a check or reinvest it back into the fund to buy new shares.
There are various ways to calculate yield, which can be a source of confusion for many investors. The bottom line is that if a fund's share price didn't change and it paid a 5% yield in a given year, the fund's total return would be 5% for that year.
Unfortunately, it doesn't always work that way in real life. In addition to the return provided by yield, the daily fluctuations in the share price (or "net asset value") also make a contribution to total return.
In a given year, these fluctuations can cause the total return to be higher or lower than the fund's yield. If a fund that yields 5% also has a 5% increase in its share price, its total return is 10%. If the same fund experiences a 5% decline in its share price, the total return is 0%.
Depending on the type of fund, these fluctuations can have varying degrees of impact on return. For instance, high-yield and emerging market bond funds tend to have much greater volatility than short-term bond funds that invest in higher-quality securities. Before investing in a fund, investors need to be sure they are comfortable with the potential volatility.
While a fund that invests in high yield bonds will usually have a higher yield than another bond fund that invests in higher-quality securities, the amount of principal fluctuation may not be appropriate for investors with low-risk tolerance or who may need the money in the near future.
Using yield and return together
Yield and return should be used together to help you evaluate an investment's overall performance.
Consider the earlier example of stock XYZ. Let's say XYZ shares lost value over the year and are now valued at $45 each. The total return for that investment would be negative; you would have lost $300, or 6 per cent ($200 in dividends – $500 in principal). However, the yield didn't change. You still received $200 in dividend income.
Investing in stocks based on their yield could prevent you from having to sell shares to generate income. In a market downturn, this can help you avoid selling shares at a loss.
Return can be used to assess not only individual investments, but also an entire portfolio to determine the overall performance and pinpoint whether certain underperforming investments should be sold, and the money reinvested elsewhere.
The risk factor
Risk is an important consideration for an investment's yield because high-yield investments may carry more risk.
For instance, if company B wants to sell bonds, but investors think company B is at risk of missing coupon payments and/or going bankrupt, the company likely needs to pay a higher yield on those bonds to compensate for the risk. To assess the risk of a bond in comparison to its yield, investors often look at the bond's rating. It's no surprise that the lowest-rated debt often has the highest yield. The term "high-yield" and "junk" are often used interchangeably when discussing poorly rated debt.
With stocks, if a company is paying high dividends, it may not be reinvested in the company and growth, which could jeopardize the investment long term. It's important to look at how the dividend payments fit into the company's overall financials. If, for instance, the company consistently reports negative earnings (i.e., losing money) but is still paying dividends, it may be tapping into cash on hand or other sources to afford those payments. This could signal long-term problems or even future elimination of dividends.
Investors should consider their investment goals and tolerance for risk when determining if an investment is a right fit for their portfolio. And once you're ready to pull income from your investments, consider making an appointment with a financial professional to assess your goals and help make sure your withdrawal plans are aligned with your investment objectives.
The idea of being an income investor and living off of the yield from your investments with no erosion of principal is not always realistic. Some typically tame income-producing vehicles such as U.S. Treasurys have produced losses in certain years.
While individual holdings, mutual funds, or exchange-traded funds (ETFs) in regularly tame asset classes may continue to throw off cash based upon their yield, investors may find themselves worse off if the decline in value is greater than the income yield over time, defeating their capital preservation strategy.
Funds and ETFs in these asset classes can be valid investments, but those seeking yield should understand the risks involved. Again, the positive impact of a decent yield can be wiped out quickly in a steep market decline impacting these asset classes.
Many financial publications and advisors tout the benefits of investing in dividend-paying stocks. Further, they often recommend these stocks as a substitute for typical income-producing vehicles. While dividend-paying stocks have many benefits, investors need to understand that they are still stocks and are subject to the risks faced by investing in stocks. This also is true when investing in mutual funds and ETFs that invest in dividend-paying stocks.
High-yield bonds are another vehicle used by investors reaching for yield—also known as junk bonds. These are below-investment-grade bonds, and many of the issuers are companies in trouble or at an elevated risk of getting into financial trouble. Individual investors often purchase High-yield bonds through a mutual fund or ETF. This minimizes the risk of default as the impact of any one issue defaulting is spread among the fund's holdings.
Depending upon the needs and situation of a given investor, a well-balanced portfolio can include both income-generating investments and those with the potential for price appreciation.
One major benefit of using a total return approach is the ability to spread your portfolio across a wider variety of asset classes that can actually reduce overall portfolio risk. This has several benefits for investors. It allows them to control where the income-producing components of their portfolio are held. For example, they can hold income-generating vehicles in tax-deferred accounts and those geared towards price appreciation in taxable accounts.
This approach also allows investors to determine which holdings they will tap for their cash flow needs. For example, after a period of solid market returns, it might make sense to make some long-term capital gains as part of the rebalancing process.
Investors should understand the key differences between yield and total return, so their portfolios are constructed to meet income-generating needs while providing a level of growth for the future.
Capital gains result in an equivalent reduction in the fund's share price (i.e., a fund with a $10 share price that pays a 20-cent distribution will see its share price drop to $9.80). Despite the drop in share price, the total return is unchanged because you've received the difference in the capital gains distribution.
Investors can either reinvest the proceeds by buying more shares, or they can take the distributions as income. Either way, a person who holds a fund in a taxable account will usually have to pay taxes on the distribution—which means that the after-tax total return will be reduced by the amount of tax paid.
Both yield and return refer to what an investor might earn on fixed investment. People often confuse the terms, but there are a few important distinctions between the two. The more forward-thinking of the two concepts, yield expresses itself in a percentage form. Also, it refers to the income earned on an investment over time. Return, however, focuses on an investment's past earning and expresses itself in a dollar amount.
Be careful not to confuse yield with the rate of return. Both are percentages that express what an investor stands to earn on particular security, but the rate of return takes into account capital gains, and yield does not.
Investors need to take care not to confuse yield with a total return. Just because a fund has a reported yield of 7% doesn't mean that's the actual return on your investment. In a given year, fluctuations in the bond fund's share price, the fund's capital gains distribution to its shareholders, and the particulars of your own tax situation mean that your after-tax return will likely differ.