What Is Yield in Finance?

Amongst the many metrics which investors use to analyse potential investments are yields. Yields measure the earnings generated on an investment over a period of time, typically a year. Keep reading to learn more about yield meaning in the financial markets, how to calculate bond yield and dividend yield and much more!

What Is Yield in Finance?

A yield measures the income received from an investment over a period of time and is expressed as a percentage of either the original investment amount, the current market value or the face value of the asset in question.

They are used to express income generated on a variety of assets, but you’ll probably hear it most frequently used when discussing stocks and bonds.

For each asset, there are a number of different types of yield which are used for different purposes. However, for the purposes of this article, we will mainly focus on the most commonly used yield meanings.

Dividend Yield Meaning

There are actually several different types of yield used to demonstrate the dividend yield of stocks.

Typically, unless stated otherwise, the term dividend yield on its own will refer to the trailing/historic dividend yield of a stock. This measures the dividends distributed over the last year per share as a percentage of the current share price.

There are a couple of others you may want to bear in mind. The forward dividend yield expresses the expected dividend per share over the next 12 months as a percentage of the current share price.

The yield on cost is less frequently used than the other two but expresses a stock’s current dividend as a percentage of the price initially paid for the stock.

Bond Yields Explained

As with stocks, there are a number of different yields which highlight different things when it comes to bonds.

However, typically, when you hear the term bond yield, people are referring to the current yield, also known as the running yield, of the bond which measures a bond’s annual interest payment, known as the coupon, as a percentage of its current market value.

Another important and commonly used term to bear in mind is the coupon rate, also known as the nominal yield, which measures a bond’s coupon as a percentage of its face value.

Yield to maturity is another metric sometimes used which measures the annualised expected total return of a bond if it is held until maturity. It assumes that all coupons are paid on time and that the bondholder is able to reinvest the coupon payments at the same rate of return as the bond.

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How to Calculate Dividend Yield

Yields are usually expressed as a percentage and the most frequently used are straightforward for investors to calculate. In the case of trailing dividend yields, investors must firstly find out how much a stock’s dividend per share was over the last 12 months as well as the current share price.

Example Calculation for UK Stocks

Let’s take a look at a real-world example in the UK stock market.

Legal & General Group (L&G) is a UK financial services company and is a constituent of the UK’s FTSE 100 stock index. The company has a good reputation as a dividend stock, having increased or maintained its annual payout each year since 2009, when it slashed distributions during the financial crisis.

L&G pay dividends twice a year and, at the time of writing, it has distributed a total of 20.63p per share over the last 12 months. Its most recent closing price was 223.50p.

Consequently, at the time of writing, L&G has a dividend yield of 9.2% [(20.63/223.50) * 100]. As one of the variables used to calculate the dividend yield is the current share price, a stock’s dividend yield can fluctuate throughout the trading day.

How to Calculate Bond Yields

The process of calculating bond yield is similar to that of calculating a dividend yield. In order to do so, you first need to establish the bond’s coupon and its current market value.

Unlike a dividend stock, where annual payouts can vary from year to year, most bonds have a fixed coupon, which remains the same throughout the bond’s term. However, some bonds do have variable coupons.

Example Calculation for UK Bonds

Let’s take a look at an example using UK treasury issued bonds, otherwise known as gilts.

At the time of writing, the latest closing price for 1% Treasury Gilt 2032 was £80.79. These gilts have a coupon rate of 1% and reach maturity in 2032. Gilts are quoted in terms of price per £100 face value.

Consequently, at the time of writing, 1% Treasury Gilt 2032 has a current yield of 1.24% [(1/80.79) * 100].

How to Interpret Yields

For those unfamiliar with bonds and/or stocks, it might seem logical to assume that bonds and stocks with higher yields are the most attractive. This is not necessarily the case, and this highlights the importance of looking beyond yields when making investment decisions.

Bonds are generally seen as lower risk investments than stocks. However, that does not mean they are without risk. Defaults can, and do, happen and the risk of this happening will depend largely on the bond issuer. Generally speaking, the higher the risk of default, the higher the yield of the bond.

The most risky, higher yielding bonds are typically referred to as “junk” bonds. The least risky – and, consequently, lower yielding – bonds are referred to as “investment grade” bonds.

With dividend stocks, the relationship between yield and risk is not so clear cut. Again, it may seem logical to assume that the most attractive dividend stocks are the ones with the highest yields. However, sometimes, high dividend yields can cause alarm bells for investors.

If the current payout is too high, it may not be sustainable in the long-term, meaning that there is a possibility of dividends being cut in the future. Furthermore, dividend yields have an inverse relationship with a stock’s current share price. This means that a high dividend yield could be the result of a falling share price, which may be a reason to stay away.

Dividend Yields vs Bond Yields

Dividend yields and bond yields essentially express the same thing: how much income investors may generate from their investment in percentage terms. However, differences begin to emerge when you look beyond the yields and at the payments themselves.

As mentioned already, many bonds have fixed coupons, meaning that investors know up front exactly how much income they should generate from a particular bond (assuming the issuer does not default).

Bonds which have variable coupons, such as floating-rate notes, adjust payments periodically according to predetermined formulae which are usually linked to a benchmark. Although these bondholders may not know exactly how much income they will generate from these types of bonds, they will be aware of the mechanism determining future payments.

Dividends are different. Distributions for stocks which pay dividends can vary from year to year. They are often based on earnings and, consequently, may be harder to predict. Furthermore, companies are not obliged to pay shareholders a dividend. Even the most reliable dividend paying stock may choose to slash or suspend payouts amidst challenging conditions in order to preserve cash.

Comparing Yields of UK Stocks and Bonds

We should be careful of drawing too many comparisons between different asset classes based on yield alone. Even when comparing within the same asset class, it is important to consider other factors and to remember that a high yield may actually be a red flag as opposed to a green one.

At the time of writing, interest rates remain high in the UK. This is generally beneficial to both the current yields and coupon rates of bonds.

Bond prices and interest rates have an inverse relationship. When interest rates rise, the prices of existing bonds fall, which means that current yields rise. Coupon rates of newly issued bonds will also tend to rise as bond issuers have to make bonds competitive with the higher rates offered by bank deposits.

This can be observed by looking at the yields of UK gilts. In August 2024, the average yield of UK ten-year gilts was 3.95%. Five years previously, in August 2019, the average yield was 0.50%.

If we look at the current dividend yields of UK stock indices, they are slightly lower at the time of writing. The FTSE 100, which is made up of the 100 largest companies listed on the London Stock Exchange, has a dividend yield of 3.57%. The FTSE 250, which is composed of the next 250 largest companies, has a current yield of 3.34%.

Subsequently, in this high-interest rate environment, bonds may be more appealing to income investors. However, although the major UK stock indices have lower average dividend yields, stocks offer greater potential for capital appreciation than bonds, whose returns are mostly comprised of coupon payments.

Final Thoughts

Yields demonstrate the amount of income an investor can expect to generate from holding a particular investment. They are of particular use to investors who prioritise generating income from their portfolio.

However, as with any financial metric, investors should look beyond yields and analyse other factors before making investment decisions. Whilst a high yield may look attractive on the surface, it can also be a red flag.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.