Wednesday 21 September 2011

Understanding Yield

I came across an interesting article on yield by John Hussman (written in 1998) that set me thinking that most of us (me included) haven't thought deeply enough about yield and what it means for our investment strategy.

Investments that produce income can be valued based on their future incomes. The standard way to measure this is 'yield' - the ratio of (annual) income divided by price. There are different types of 'yield':
  • 'running', 'income' or 'historical' yield -  the most familiar type of yield, based on the latest known information
  • forecast yield, usually relating to shares, based on forecasts of both share price and dividend payments
  • 'yield-to-maturity', typically used for fixed-interest securities that mature and return the 'face value' - the yield-to-maturity is the average annual return that you would receive if you hold the security to maturity

As Hussman points out, the long-term return on a security breaks into two elements:
  • income (e.g. from dividends or interest payments)
  • capital gains (e.g. from price changes or maturity of a security).

An important basic concept to grasp is that for any future stream of income (in the form of dividends, interest or bond coupon payments, the higher the price you pay now, the lower the average annual rate of return or yield that you will earn over the period you hold that security. So, in other words, there is an inverse relationship between the future long-term return on a security and the current price.

Take an (unusual) example of a 30-year zero-coupon bond (i.e. with no income) with a 'nominal' or 'face' value of £100. If the bond is priced at a yield-to-maturity of 10%, it will cost you only £5.73 today - mainly because there is no income for 30 years but then you will be paid £100. However, because you paid so little for it initially your annualized return will be 10%.

But consider what might happen during those 30 years. Suppose that over the first 10 years of your holding period, general interest rates decline, making your security more attractive and therefore resulting in an increase in its price. Let's say the yield-to-maturity on your bond falls to 7% (remember, because the selling price has increased). With 20 years remaining to maturity, the price of the bond would be £25.84. Of course, none of this changes the yield-to-maturity that you bought when you acquired the security.

OK? With me so far?

Now here's the crucial point. Even though the yield-to-maturity for the remaining life of the bond is just 7%, and the yield-to-maturity you bargained for when you bought the bond was only 10%, the return you have earned over the first 10 years is an impressive 16.26% (because the price has increased)!

So, by holding the security during a period when the yield-to-maturity is falling (because the price is increasing), you not only earn a return that is higher than the original yield to maturity, you earn a return that is dramatically higher than the future yield-to-maturity!

However, over the remaining 20 years of the bond, you will not earn 16.26% annually, but only 7%. And, of course, if you hold it for the entire 30 year holding period, you will have made - surprise - 10% annually - what you bought originally. So should you have sold when things were going well? Probably.

A similar analysis can be applied to shares; here there is no real 'yield-to-maturity' as there is no guarantee that you will be repaid the 'nominal' value of the share - the final selling price at any time will be set by the market. However, the total yield - let's continue to call it 'yield-to-maturity' comes from the same two components: income and capital gain. The income component is simply the dividend. 

My own take on this is the 'rule' that I have for selling (although 'more in the way of guidelines' to quote Pirates of the Caribbean) 
  • if the increase in capital value is equivalent to 5 years' income
  • if the current yield is less than 3.5%

Conversely, you want to buy shares or bonds when the dividend/coupon yield is high, or while favorable market action (interest rates, inflation expectations) are driving the yield downward (by increasing the share price). But not when neither is true.

However, the key advantage of bonds and other 'maturing' securities is that even if the yield increases (and the security price falls)  you can hold on for the yield-to-maturity. With shares you don't really have that option.

Anyway, are interest rates going to go up or down? And what will yields do then? Maybe the strategy today is to 'lock in' a good 'yield-to-maturity' and hold on? Any ideas?



I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

3 comments:

  1. Just been looking at the wild market ride and thinking of selling rules and yours make pretty good sense.

    In an ideal word would mean you always get out at the topish of the market and start jumping back in at the bottomish and the small movements don't matter.

    As usual though discipline is the key in succesful investing - so easy to say so difficult to implement.

    I bought CW a while ago after reading about it here and am interested in your plans regarding that as it has lost considerable value but possibly has a high yield.

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  2. @Anonymous
    Yes, CW was a bit of a gamble, that has not really worked. A very high yield at present but the dividend will be cut by half - still not a bad yield. So I'm holding for now.

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  3. Such great article which investments that produce income can be valued based on their future incomes. The standard way to measure this is 'yield' - the ratio of (annual) income divided by price. It such a informative and interesting article.

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